The next capitalist revolution

Market power lies behind many economic ills. Time to restore competition

CAPITALISM HAS suffered a series of mighty blows to its reputation over the past decade. The sense of a system rigged to benefit the owners of capital at the expense of workers is profound. In 2016 a survey found that more than half of young Americans no longer support capitalism. This loss of faith is dangerous, but is also warranted. Today’s capitalism does have a real problem, just not the one that protectionists and populists like to talk about. Life has become far too comfortable for some firms in the old economy, while, in the new economy, tech firms have rapidly built market power. A revolution is indeed needed—one that unleashes competition, forcing down abnormally high profits today and ensuring that innovation can thrive tomorrow.

Countries have acted to fuel competition before. At the start of the 20th century America broke up monopolies in railways and energy. After the second world war West Germany put the creation of competitive markets at the centre of its nation-building project. The establishment of the European single market, a project championed by Margaret Thatcher, prised open stale domestic markets to dynamic foreign firms. Ronald Reagan fostered competition across much of the American economy.

A similar transformation is needed today. Since 1997 market concentration has risen in two-thirds of American industries. A tenth of the economy is made up of industries in which four firms control more than two-thirds of the market. In a healthy economy you would expect profits to be competed down, but the free cashflow of companies is 76% above its 50-year average, relative to GDP. In Europe the trend is similar, if less extreme. The average market share of the biggest four firms in each industry has risen by three percentage points since 2000. On both continents, dominant firms have become harder to dislodge.

Incumbents scoff at the idea that they have it easy. However consolidated markets become domestically, they argue, globalisation keeps heating the furnace of competition. But in industries that are less exposed to trade, firms are making huge returns. We calculate the global pool of abnormal profits to be $660bn, more than two-thirds of which is made in America, one-third of that in technology firms (see Special report).

Not all these rents are obvious. Google and Facebook provide popular services at no cost to consumers. But through their grip on advertising, they subtly push up the costs of other firms. Several old-economy industries with high prices and fat profits lurk beneath the surface of commerce: credit cards, pharmaceutical distribution and credit-checking. When the public deals with oligopolists more directly, the problem is clearer. America’s sheltered airlines charge more than European peers and deliver worse service. Cable-TV firms are notorious for high prices: the average pay-TV customer in America is estimated to spend 44% more today than in 2011. In some cases public ire opens the door to newcomers, such as Netflix. Too often, however, it does not. Stockmarkets value even consumer-friendly entrants such as Netflix and Amazon as if they too will become monopolies.

Rising market power helps solve several economic puzzles. Despite low interest rates, firms have reinvested a stingy share of their bumper profits. This could be because barriers to competition keep out even well-funded newcomers. Next, since the turn of the millennium, and particularly in America, labour’s share of GDP has been falling. Monopolistic prices may have allowed powerful firms to eat away at the purchasing power of wages. The labour share has fallen fastest in industries with growing concentration. A third puzzle is that the number of new entrants has been falling and productivity growth has been weak. This may also be explained by a lack of competitive pressure to innovate.

Some argue that the solution to capital’s excesses is to beef up labour. Elizabeth Warren, a possible American presidential candidate, wants to put more workers on boards. Britain’s Labour Party promises compulsory employee share-ownership. And almost everyone on the left wants to reinvigorate the declining power of unions (see Briefing). There is a role for trade unions in a modern economy. But a return to 1960s-style capitalism, in which bloated oligopolies earn fat margins but dole cash out to workers under the threat of strikes is something to be avoided. Tolerating abnormal profits so long as they are distributed in a way that satisfies those with power is a recipe for cronyism. Favoured insiders might do well—witness the gap between coddled workers and neglected outsiders in Italy. But an economy composed of cosy incumbents will eventually see a collapse in innovation and hence a stagnation in living standards.

Far better to get rid of rents themselves. Market power should be attacked in three ways. First, data and intellectual-property regimes should be used to fuel innovation, not protect incumbents. That means liberating individual users of tech services to take their information elsewhere. It also entails requiring big platforms to license anonymised bulk data to rivals. Patents should be rarer, shorter and easier to challenge in court.

Second, governments should tear down barriers to entry, such as non-compete clauses, occupational licensing requirements and complex regulations written by industry lobbyists. More than 20% of American workers must hold licences in order to do their jobs, up from just 5% in 1950.

Third, antitrust laws must be made fit for the 21st century. There is nothing wrong with trustbusters’ remit to promote consumer welfare. But regulators need to pay more attention to the overall competitive health of markets and to returns on capital. America’s regulators should have more powers, as Britain’s do, to investigate markets that are becoming dysfunctional. Big tech firms should find it much harder to neutralise potential long-term rivals, as Facebook did when it acquired Instagram in 2012 and WhatsApp in 2014.

These changes will not solve every ill. But if they drove profits in America to historically normal levels, and private-sector workers got the benefits, real wages would rise by 6%.

Consumers would have greater choice. Productivity would rise. That might not halt the rise of populism. But a competition revolution would do much to restore the public’s faith in capitalism.

Xi versus Deng, the family feud over China’s reforms

The anniversary of ‘reform and opening’ has sparked a contest of narratives about who was responsable

Lucy Hornby in Shenzhen

© Imaginechina

At the end of last year, an exhibition opened in the southern Chinese city of Shenzhen with a frieze at the entrance depicting former “paramount” leader Deng Xiaoping touring the region that is synonymous with China’s reform era.

Over the summer, the gallery closed for renovations. When it reopened in August, a quote from President Xi Jinping in Chinese and English, praising the country’s economic transformation, had replaced the frieze.

In September, the entrance was changed again to include quotes from Messrs Xi and Deng. By November, the gallery had reverted to the original plan and the frieze was back.

The hasty series of revamps illustrates the dangers lurking in the staid world of Chinese Communist iconography.

As China prepares for the 40th anniversary of the reforms next month, Shenzhen has found itself at the centre of a proxy battle between China’s two most powerful families that combines politics, history and power. The battle has played out in galleries like the one in the Shekou district of the city, which was the launch point for the “reform and opening” era.

For Mr Xi and his family, the anniversary is an opportunity to set the historical record straight about the role that his father, Xi Zhongxun, played in pushing the reforms that transformed China from a poor and isolated backwater into the world’s second-largest economy. The elder Mr Xi was at one stage the senior official in charge of Guangdong, the southern Chinese province which includes Shenzhen. It became the test bed for a more market-based economy.

The frieze depicting “paramount” leader Deng Xiaoping touring the Guangdong region, which has been restored to a Shenzhen art gallery

Formal celebrations of the 40th anniversary are expected to feature Mr Xi and his “new era” of Chinese socialism, which he defines as building on the legacies of both Deng and Mao Zedong. His image centres on a strong leader standing up for China in the world.

Through shaping the presentation of the crucial period in the late 1970s and early 1980s, Mr Xi is keen to associate his name and that of his family with the reform process, which has become so closely linked with Deng.

“Reinforcing Xi’s direct family links to the genesis of reform reinforces how crucial that period was, and the legitimisation it confers,” says Kerry Brown, director of the Lau China Institute at King’s College London.

The perception that Mr Xi is downgrading Deng’s role has only added to fears that a new cult of personality is developing around the current leader. The tussle over the legacy of reforms comes after the constitution was changed this March to allow Mr Xi to rule for life. Critics believe that his increasingly statist and authoritarian approach threatens some of the Deng era achievements.

In a September speech, Deng’s son Deng Pufang called for a return to the reform era priorities of fixing China’s domestic problems while maintaining stable external relations — an implied dig at the current trade war with the US, slowing domestic growth and the triumphalist propaganda that Mr Xi has cultivated. Given that China remained a relatively poor country yet faced international instability and uncertainty, Mr Deng said “the crucial issue is to get China’s own problems right.” The remark must have stung because Chinese media did not report the speech.

People pose for photos in front of a billboard to Deng Xiaoping in Shenzhen

For Mr Xi, there is a political risk involved in appearing to contest Deng’s role. Reverence among Chinese for Deng as the “architect” of the reform era is hard to overestimate. “He is our leader,” says Liang Yuanrong, a small-business owner, as he stopped to take a photo of a billboard depicting Deng in Shenzhen. “If it weren’t for him, our life today wouldn’t be as flourishing.”

After becoming general secretary of the Chinese Communist party in 2012, Mr Xi did not immediately seek to dilute Deng’s place in the official narrative. In his first term, Mr Xi adopted the symbolism of the Deng era. He travelled to Shenzhen in 2012 and laid a wreath at Deng’s statue. The following year, at the third plenum of the 18th party congress, the party echoed the famous plenum of 1978 by releasing a laundry list of long-promised — and still not fully implemented — economic reforms.

In 2016, Mr Xi visited Xiaogangcun, the village in Anhui province that symbolises the rural reforms of the Deng era, to announce his own vision for reconsolidating farmland.

However, ahead of the 40th anniversary celebrations, ideological and personal divisions among the two elite Chinese families have appeared. The fight has coalesced around Xi Zhongxun’s role in establishing Shenzhen as China’s pilot “special economic zone” bordering Hong Kong.

Shenzhen is home to some of China’s most advanced tech companies, as well as the intense assembly-line production that powered China’s export-led growth. Back in 1978, however, it was a rural backwater. Fifteen years later, it served as the backdrop for Deng’s “southern tour”, when he rebooted economic reforms and revived foreign investment flows following his bloody crackdown on the 1989 Tiananmen Square protests.

How to tell the story of China’s economic reforms in 2018 is a delicate issue because Shenzhen holds personal significance for the Xi family. Xi Zhongxun was posted to Guangdong province shortly after the end of the Mao era. There he officiated over plans to turn Shenzhen, and Guangdong province more generally, into an export-oriented manufacturing hub to attract foreign investment and precious hard currency to impoverished China. He retired to Shenzhen after falling out of favour with Deng in the late 1980s. He died in 2002.

There’s a feeling among the Xi family that Deng never gave their father appropriate credit for Shenzhen,” says Dennis Wilder, managing director for the Initiative for US-China Dialogue on Global Issues at Georgetown University. “There seems to be some bitterness.”

Deng Xiaoping blamed Wan Li and Zhao Ziyang for the Tiananmen Square protests of 1989 but they are associated with significant agricultural reforms © AP

This summer, an exhibition at the National Art Museum of China in Beijing commemorating the 40th anniversary of the reforms featured a painting with Xi Zhongxun pitching the concept of a special economic zone in Shenzhen to a seated Deng. The painting was quickly removed after it sparked a furore on the internet.

Because the picture depicted Xi Zhongxun, not Deng, standing at the centre, critics accused Mr Xi’s loyalists of usurping Deng’s place as the “architect” of the reforms.

At an anniversary exhibition that opened in Beijing’s National Museum of China on Tuesday, Mr Xi’s photo was the most prominently displayed. Deng was relegated to equal status with other former leaders of the reform period, Jiang Zemin and Hu Jintao.

Deng Xiaoping's son Deng Pufang, centre © Bloomberg

Other flattering images that elevate Mr Xi and diminish Deng — including a touring painting in which Deng is reduced to a far-off statue — have been similarly derided.

That may explain Mr Xi’s cautious reaction when he toured yet another exhibition on reform last month, this one at the new Museum of Contemporary Art in Shenzhen. Staffers said Mr Xi’s main concern was that it featured his father too much. The formal opening date was pushed back as they rushed to rebalance the exhibit.

The clash over the anniversary exhibitions is not just about family pride. It also goes to the heart of the debate in China about Mr Xi’s policies.

To the consternation of many in China, Mr Xi has reversed many Deng-era policies in favour of those more reminiscent of Mao’s time. Despite declaring that China will be “more and more open”, Mr Xi has presided over the revival of statist policymaking and a new reverence for Marxist-Leninist orthodoxy. He has tamped down divergent voices within the Communist party and tightened the screws on civil society. He has reintegrated the party with government bureaucracies, threatening the long effort to create a professional bureaucracy.

“Political reform has been dead for a decade or longer . . . even in the economic sphere, regression is taking place,” says Chongyi Feng, a professor of Chinese studies at the University of Technology Sydney and a critic of the Chinese government. “Deng’s reforms resonated with wider support from the bureaucracy and society as well.”

Shenzhen: from special economic zone to modern metropolis © Bloomberg

Under Mr Xi, state-owned enterprises have been elevated in status and he has presided over a squeeze on private companies, which were legalised in the 1980s. Political campaigns and factional purges have been revived under the cover of his anti-corruption drive. Portraits and sayings by Mr Xi extolling the party are everywhere, prompting talk of a fresh cult of personality. The removal of presidential term limits alarmed many of China’s supporters abroad.

When Mr Xi returned to Shenzhen this October, critics noted that he had failed to mention Deng in his speeches.

“I don’t see it as such a big snub because Deng’s policies have been snubbed for a decade already,” says Victor Shih, an expert in Chinese politics at the University of California San Diego.

The shifting historical narratives give a contemporary urgency to those defending the reformist agenda that the Deng era promoted.

President Xi Jinping front and centre, while a statue of Deng Xiaoping is a distant image in a painting at the Guangdong Museum of Art

“I am concerned that the economic model that the present government seems to be pursuing — a new kind of ‘state-led capitalism’ — may not be consistent with China’s long-term needs,” Pieter Bottelier, the World Bank’s representative to Beijing in the 1990s, told the China Development Forum in September. “Deng Xiaoping’s ‘reform and opening-up’ policies, guided by China’s long history and deep culture, pushed the country in the right direction.”

Although China is now much wealthier and competing directly with western nations, some in China now feel that a sense of direction is missing. At the beginning of the reform era it was “easy to get consensus”, says Feng Lun, one of China’s first real estate entrepreneurs. But after progressing from simply doing things differently than Mao did, to working out economic strategies and legal structures, “by the fourth decade there was a split storyline,” he says. Ideological differences mean sharply different recipes for how to deal with poverty, environmental problems and international relations.

Since Deng’s death, the party’s constant use of the word “reform” shows how important the legacy of the era is. Mr Xi has begun to use the phrase “opening up” again too. In speeches this year he has reassured audiences China’s “great door will open wider and wider”.

“Nowadays, we can’t talk about Deng’s legacy because reform is not dead. Only when something is dead does it have a legacy,” says Zhou Zhixing, chair of the US-China New Perspectives Foundation and a close associate of the Deng family.

Mr Zhou cites “liberation of thought” as the most important achievement of the reform era.

But he admits that Deng left unchanged the core structures of Communist party’s statist rule that Mr Xi has so controversially revived: “You can’t criticise Deng for that. Every generation can only fight its own battles.”

Additional reporting by Archie Zhang in Beijing

Conflicting accounts of a stop-start process

“Despite great and widespread interest both inside and outside China in this history, there is still quite limited understanding of the Chinese reform process,” Edwin Lim, the first representative of the World Bank in China in the 1980s, wrote in an essay commemorating the 30th anniversary of China’s reforms.

That’s partly because subsequent purges and a tradition of lionising the top leader make it inconvenient for the ruling Communist party to recognise contributors other than Deng Xiaoping. In the party’s simplified official version of history, Deng is portrayed as the heroic leader of reforms — and the third plenum of December 1978 as the watershed moment. In reality, the process of adopting reforms was stop-and-start, with many ideas initially opposed by the party. They were only fully endorsed once it was clear they were successful.

As Xi Jinping took power, accounts began circulating that put his father at the centre of the reform narrative. Those accounts resonate with elite families who feel Deng took credit for the collective effort of party veterans to rescue China from the disasters of the Mao era.

Souvenir plates with portraits of former Chinese leaders Mao Zedong, Deng Xiaoping, Jiang Zemin, Hu Jintao and current president Xi Jinping © Reuters

Other senior officials at the time, especially Wan Li and Zhao Ziyang — who Deng blamed for the Tiananmen Square protests of 1989 — are associated with the agricultural reforms that freed farmers from the communes. Hu Yaobang, a relative liberal who was purged by Deng in 1987, oversaw attempts to clarify corporate ownership in order to increase industrial output, a problem that still bedevils China today.

In a commemorative essay Qi Xin, Xi Zhongxun’s wife, credits her husband with pushing Guangdong to the forefront of reform experiments. “He wanted to take back the 16 lost years and do more practical things for the party and the people,” Ms Qi writes.

One party history published in 2007 says Xi Zhongxun realised in the late 1970s that Chinese captured trying to flee to Hong Kong could find work if factories were built on the Chinese side of the border instead. That was the origin of the “special economic zones” like Shenzhen.

In his 2011 biography of Deng Xiaoping, however, American historian Ezra Vogel credits that insight to Deng in 1977. He writes that Xi was a strong advocate in getting Beijing’s support for Guangdong’s reforms.

“At the time, turning it into a central policy certainly needed Deng’s OK. But actually not all the experiments at the local level that started after Mao’s death were Deng’s idea,” says Zhang Lifan, a Beijing-based historian. “There wasn’t any ‘architect’. Everyone had their programme and then those became the blueprint.”

Has This Become A “Short Everything In Sight” Market?

by John Rubino

One of the strangest things about this strangest-ever expansion has been the way pretty much everything went up. Stocks, bonds, real estate, art, oil – some of which have historically negative correlations with others — all rose more-or-less in lock-step. And within asset classes, the big names behaved the same way, rising regardless of their relative valuation.

This seemingly indiscriminate buying created a paradise for index funds that simply accumulate representative assets in their chosen sectors. And it made life a nightmare for the higher-order strategies of hedge funds that get paid to beat the market.

The cause of all this, of course, was the tsunami of new currency being created by the world’s central banks and dumped into the banking system. It had to go somewhere and ended up going everywhere.

But now the central bank spigot is being turned off, and everything is heading back down the same way it rose — in lock-step. From today’s Wall Street Journal:
No Refuge for Investors as 2018 Rout Sends Stocks, Bonds, Oil Lower 
Stocks, bonds and commodities from copper to crude oil to burlap are staging a rare simultaneous retreat, putting global markets on track for one of their worst years on record and deepening a sense of unease on Wall Street. 
By one measure, global stocks and bonds are both on track to finish the year in the red for the first time in at least a quarter-century, said Belinda Boa, head of active investments for Asia Pacific at BlackRock in Hong Kong. Major stock benchmarks in the U.S., Europe, China and South Korea have all slid 10% or more from recent highs. Crude oil’s tumble has dragged it well into bear market territory, emerging-market currencies have broadly fallen against the U.S. dollar, and bitcoin’s price—which had a meteoric rally last year—crashed below $5,000 this past week for the first time since October 2017. 
Asset class performance short everything in sight
Havens such as U.S. Treasury bonds and gold rallied this fall as U.S. stocks and industrial commodities staged their fourth-quarter swoon. But both are still down on a price basis for the year, reflecting solid economic growth and tighter Federal Reserve policy that have begun to push interest rates out of their post-financial crisis doldrums. 
All told, 90% of the 70 asset classes tracked by Deutsche Bank are posting negative total returns in dollar terms for the year through mid-November, the highest share since 1901. (The S&P 500 is up slightly in 2018 on a total-return basis.) Last year, just 1% of asset classes delivered negative returns.

The broad pullback in markets is leaving fund managers scrambling to find places to park their money. But with global growth showing signs of slowing and monetary policy expected to tighten further, few are eager to place large wagers and risk compounding earlier failures to generate expected gains. Indeed, the simultaneous failure of so many investment strategies is being by viewed by some as a warning of what could come following years of above-average returns. 
“It’s been a difficult year,” said Ed Keon, chief investment strategist at asset-management firm QMA, which continues to favor stocks over bonds. “All investors have goals, and none of those can be fulfilled with negative returns.” 
Few investors believe a recession, particularly in the U.S., is imminent. Yet the strength of the U.S. economy has allowed the Federal Reserve to continue stepping further away from the regime of rock-bottom interest rates and bond-buying put in place after the financial crisis. That has, in turn, diminished the premium investors get for taking on risky assets, pressuring a variety of markets. 
Hedge-fund manager Pierre Andurand, who earlier in the year bet oil could soon hit $100 a barrel, saw his $1 billion Andurand Commodities Fund suffer its largest monthly loss ever in October. Funds that had built up large stakes in fast-growing technology companies were also stung by sharp reversals. Twenty-six funds dumped their entire stakes in FacebookInc. in the third quarter, according to a Goldman Sachs Group analysis of 13F filings, including billionaire Daniel Loeb’s Third Point LLC, which offloaded 4 million shares, citing “a very disappointing quarter” for Facebook. 
“It hasn’t felt like a bad year, but retrospectively, it’s been a pretty miserable year,” said Thomas Poullaouec, head of multiasset solutions for Asia Pacific at T. Rowe Price in Hong Kong. “2019 isn’t looking to be any better either.”

This shouldn’t come as a surprise, since virtually every asset class except for precious metals started the year at “priced for perfection” valuation levels that have always in the past preceded some kind of crash. It’s just more widespread and homogenous this time.

So now all the geniuses who bought the big names in random categories and made easy money are wondering why every single thing they do is suddenly wrong, while the handful of remaining short-sellers are finding that whatever they bet against goes down.
This kind of wide-spread angst ought, if history is still a useful guide, lead investors to start discriminating again, with safe havens like gold and high-grade bonds getting some of the attention that tech and cryptos have hogged recently.

Standing on Guard for an Economic Crisis in Canada

By Xander Snyder        



Canada’s economy, the world’s 10th-largest, looks to be chugging along nicely. Though low oil prices slowed it down in 2014-2015, it grew by 3 percent last year, with help from each of the country’s provinces. But this growth has come at a cost: debt. Canada’s debt is piling up, creating vulnerabilities that could make recovery more difficult for the country in the event of another recession. This Deep Dive will investigate the scale of Canadian debt, with an emphasis on consumer debt, and whether its associated risks could spread beyond Canada.
Warning Signs
That Canada was accumulating more debt was no secret. But the extent of the risk that debt has created became more apparent earlier this year when the Bank for International Settlements published the latest edition of its report “Early warning indicators of banking crises.” The paper lays out several metrics that have a statistically significant effect on predicting future banking crises, while minimizing the chance of a false positive, or a crisis that was forecast but doesn’t happen. The metrics include the difference between current and historical ratios of private, nonfinancial debt to gross domestic product – the credit-to-GDP gap – and the ratio of outstanding debt to income, known as the debt service ratio, at the national and household levels. When these early warning indicators cross a certain threshold, the BIS highlights them in amber. When they cross a higher threshold, indicating an even greater likelihood of a banking crisis, it turns them red. All of Canada’s indicators are red or orange, meaning conditions in the country’s banking system are favorable for a crisis within the next three years.

Household debt is a big part of this equation. Canada currently has roughly 2.5 trillion Canadian dollars (or about $2 trillion) in household debt – the equivalent of approximately 170 percent of Canadian disposable income. In other words, for every dollar earned, the average household owes C$1.70 in debt. And that’s just the average; about 8 percent of Canadian households have debt equivalent to 3.5 times their gross income, making up about 20 percent of Canada’s total household debt.
Most of Canada’s household debt comes from mortgages. Since the end of 2008, low interest rates in the country have made credit more available and less expensive. Demand for housing has, in turn, increased – and with it, housing prices. At the end of last year, the Organization for Economic Cooperation and Development estimated that Canada’s housing prices were overvalued by approximately 50 percent relative to prevailing rental rates. Higher housing prices, and, by extension, higher collateral value, justified larger loans, while low interest rates made bigger debts easier for borrowers to service. The result was a kind of feedback loop. Meanwhile, Chinese capital flooded the Canadian real estate market as investors in China looked for hard assets to acquire abroad. These buyers helped drive up housing prices in Canadian cities such as Vancouver, and they could drive them back down just as quickly if Beijing were to clamp down on its capital outflows. The resulting dearth of capital and the collapse of housing prices would put some homeowners in Canada underwater.

Mortgages, however, are only part of the problem. Many Canadians, like countless Americans in the runup to the 2008 financial crisis, have also taken out home equity lines of credit, or HELOCs – lines of credit secured against the value of a house. Unlike a traditional mortgage, in which a bank extends a fixed amount of credit at once for the purchase of a home, a HELOC is a guarantee that a bank will lend up to a certain amount of money as needed over a given time frame. The loans became more popular as lending increased overall, and since HELOCs often allow for interest-only payments – or at least lower principal payments – many Canadians have opted for higher HELOC interest rates than for traditional mortgages. The interest-only or lower-principal model means borrowers pay less each month than they would for a traditional mortgage, the higher interest rate notwithstanding. So lenders get more in interest, while borrowers have more cash on hand to spend elsewhere. It’s a win-win – until, of course, the principal comes due. Once a loan reaches maturity, borrowers must either pay off what’s left of their debt or refinance it. In some instances, borrowers wind up owing more on a HELOC than the value of their homes, a particular danger in inflated housing markets like those in most Canadian cities.

Paying the Piper
The possibility of interest-rate hikes adds to the risks facing borrowers. In Canada, one-quarter of all mortgages have a variable interest rate and reset more often than fixed-rate mortgages. But even fixed-rate mortgages reset every five years, compared with the 30-year fixed-rate arrangement familiar to U.S. homebuyers. The more debt a household carries, the lower its chances of being able to repay its obligations when interest rates increase. As fewer borrowers can afford to repay their debts, more loans will be at risk of becoming nonperforming, putting strain on the Canadian financial system.
Put simply, rising interest rates will have an outsize effect on Canada’s consumer spending. But as the central bank boosts interest rates – as it has already done five times since May, bringing them from 0.5 percent to 1.75 percent – it will add to the stress on borrowers. A recent poll by the Canadian Broadcasting Company showed that nearly 60 percent of Canadians could not afford to pay C$100 more a month toward their debt (or any other expense) without changing their spending habits. That means three more interest rate hikes of 0.25 percent are all it would take to drive households with $200,000 or more in mortgage and HELOC debt to modify their spending. Considering the average household debt in nearly all of Canada’s major metropolitan areas is at least that high, a large share of Canadians may soon have to curb their spending.

Interest Rates and External Debt: A Tricky Situation
That’s troubling news, not only for the average Canadian citizen, but also for the government.  As the U.S. Federal Reserve continues its monetary tightening, the U.S. is facing the conundrum that plenty of other states around the world are: try to keep up with the Fed’s rate hikes and risk overcorrection, or take it more slowly and risk currency depreciation. (If interest rates climb faster in the U.S. than elsewhere, capital will flow there in search of greater returns.) Canada stands to take a hit either way. Although it is a major energy exporter, consumption and residential investment have accounted for more than 90 percent of its economic growth since 2009. Boosting interest rates could dampen consumer spending by increasing household expenses and decreasing disposable income. On the other hand, if the central bank doesn’t keep raising interest rates, or doesn’t raise them quickly enough, the differential with U.S. interest rates will cause the Canadian dollar to depreciate.

The substantial debt burden of the average Canadian household could also complicate the Bank of Canada’s efforts to keep inflation between 1 and 3 percent, and preferably right around 2 percent. Its previous interest rate hikes aimed to lower inflation, which has hovered above 2 percent for most of the year. But because the average household has so little wiggle room in its finances, even small interest rate increases can affect consumer behavior. That reality will constrain the central bank as it considers bumping up the interest rates in the future, and Canada’s rates may well wind up trailing those of the U.S.
On both counts, the result would be a higher price tag on Canada’s external debt. Currency depreciation makes external obligations denominated in foreign currencies more expensive for a country to service. And Canada’s external debt isn’t trivial, at $1.9 trillion total, of which $1.33 trillion – a sum equivalent to 80 percent of Canada’s GDP – is in non-Canadian currencies. The government will have to decide whether to raise interest rates at the expense of consumers and economic growth or hold off and pay more to service its external debt.

Risk of Infection?
The situation looks foreboding for Canada, but what about for other countries? How vulnerable another state would be to a prospective Canadian recession depends in large part on how exposed its banking system is to that of Canada. The top five countries with claims on Canada’s banking system – The United States, the United Kingdom, Japan, Germany and France – don’t have much exposure to Canadian banks. For example, the United States has $125.1 billion in claims on Canada, an amount that may seem formidable but comes to just under three-quarters of a percent of the total assets in U.S. commercial banks. These holdings are modest enough that even if Canada fell into a banking crisis on the scale of Italy’s meltdown – in which the ratio of nonperforming loans neared 15 percent – only 0.1 percent of U.S. banking assets would face a greater repayment risk. (Canada’s gross nonperforming loan ratio is in fact very low, at only about a half of a percent.)

Canada, on the other hand, is not quite as insulated from other countries. A full 25 percent of Canada’s financial system has cross-border claims on the U.S., in part because of the large trade volume between the two countries. So while the U.S. would be more or less safe from a Canadian recession, the same would not be true for Canada in the event of a U.S. recession. That Canada derives about one-fifth of its GDP from trade with the U.S. makes it all the more susceptible to fluctuations in the American economy. Its vulnerability to the United States has become more apparent than usual since Washington reopened negotiations on the North American Free Trade Agreement.
On Unequal Footing
To better buffer itself from the vagaries of U.S. economic policy in the long term, Canada, like Mexico, will look for ways to diversify its trade partners. Doing so won’t be easy. Much of Canada’s trade with the United States is in energy, which requires extensive (and expensive) transport infrastructure, such as pipelines. Building new pipelines to send Canadian energy exports to new markets will take too much time and money for it to be a quick fix. Even so, Canada will need to find new energy buyers sooner or later; as the U.S. oil and natural gas industry becomes more self-sufficient, the United States will need less and less Canadian energy.
Canada isn’t totally at the whim of the United States, however. Ottawa has proved willing to push back against U.S. policies that challenge Canadian businesses. For instance, despite the inclusion in the United States-Mexico-Canada Agreement of a clause requiring all members to review any bilateral trade negotiations between a signatory state and a “non-market” economy, Canada says it nevertheless plans to pursue further trade agreements with China, the obvious, if tacit, object of the provision. It even helped China place four deep-sea monitoring devices in the Pacific Ocean late last month and connect them to its system of marine observatories. The sensors, which provide real-time data to the Chinese Academy of Sciences, are ostensibly for research purposes, though their proximity to two U.S. naval bases – one is the only West Coast base that can support dry-docking of Nimitz-class aircraft carriers, and the other houses nuclear submarines – adds a shadow of doubt to that claim.
It’s hard not to read Canada’s cooperation with China on these marine sensors as a message to the United States. What’s more, it’s easy enough to imagine that if Washington stands firm on its trade agenda, a nationalist party could take power in Canada and more aggressively pursue alternative trade partners to distance it from the United States. (The odds of it happening in the 2019 federal elections are slim, since Canadian consumers would probably need to experience a fair amount of financial discomfort before they move in that direction.) China would make a poor substitute – it’s far away, it’s not nearly as integrated with the Canadian economy as the U.S. is, and its consumer base isn’t as strong. But it may still be better than nothing, especially given Canada’s need for leverage in its trade dealings with the U.S. The transition won’t happen overnight, if it happens at all; Canada’s deep, structural economic reliance on the United States. would take years to break.
In the meantime, Canada has more immediate economic problems to contend with. The early warning indicators identified may not portend certain doom for the Canadian economy, but they don’t paint a picture of perfect health, either. And if Canada’s financial issues do trigger a crisis, its dependency on the United States could add fuel to the fire.

A Speech by Mike Pence and the Sum of All Chinese Fears

The Chinese are looking for any hint that Washington is escalating the conflict with Beijing.

By George Friedman

I have spent the last few days in Beijing, attending meetings and dinners. The single most striking thing I have encountered is the response to a speech U.S. Vice President Mike Pence delivered at the Hudson Institute in October. Many people interpreted the speech as an indication that the United States has decided to significantly deepen its dispute with China, moving from economic issues to a general confrontation some likened to a new Cold War. There was also an expectation that, during a meeting scheduled between Chinese President Xi Jinping and U.S. President Donald Trump at the G-20 summit later this month, some paths to accommodation might emerge.

I was surprised by the idea that the U.S.-China dispute is deepening. From my point of view, it was already deep, considering their many issues over trade and the South China Sea. I found Pence’s speech unexceptional. It criticized China on grounds the Chinese have heard many times before and ended with several paragraphs on the need for accommodation and hope that both sides will work toward this end. The Chinese were reading the speech with meticulous care, isolating certain sentences and words that were interpreted to mean that the U.S. intended to enter into a new Cold War.

This incident reminded me of the real Cold War with the Soviet Union. Each side, not really certain how power was constructed in the other, read every word and reviewed every photograph that came out of its adversary, trying to determine where power lay and how that would change its strategy. Sometimes very strange conclusions were drawn. When President Richard Nixon was forced from office, the Soviets believed that a coup d’etat had taken place, engineered by opponents of Nixon’s policy of detente with the Soviet Union. I recall that when the Soviets invaded Afghanistan, some saw the invasion, in addition to some incidents in Iran and the Persian Gulf, as an indication that Afghanistan was the preface to a Soviet move to close the Strait of Hormuz.

Each side looked at events from the standpoint of their worst fears and connected totally unconnected things to make the case. The Soviets saw intense criticism of Nixon’s Soviet policy in what they thought were influential journals (but really weren’t). When Nixon resigned, the Russian view was that it was all about them, and they marshaled the evidence to show it. During the fall of the Shah and the 1973 oil embargo, the U.S. was obsessed with the Persian Gulf, and some reasonable people thought that an invasion of Afghanistan was an appropriate preface to choking off the flow of oil from the Middle East. Each nation has its own fear, and analysts in every country look for evidence that the worst is going to happen. Watergate had nothing to do with the Soviets, and Afghanistan had nothing to do with the Persian Gulf.

The fear in China is that the United States is going to intensify the conflict. The Chinese are looking for indications that this might happen, and they found it in a speech made by the vice president. In the United States, a speech delivered by the vice president in front of a think tank wouldn’t be the venue to convey a dramatic shift. Given the politics involved, it would be managed very differently. But in China, the first hint of a policy change might well come from a fairly obscure speech. The Chinese fears found grounding in an address that didn’t really break any new ground, and that wouldn’t be the place new ground would be broken anyway.

The U.S. and the Soviet Union did find the means for creating somewhat trusted channels of communication. But the real foundation of trust is understanding the geopolitical constraints and imperatives of the other side. The Soviets were a defensive power so long as they controlled their buffer. The Americans were in a defensive posture all around the Soviet periphery. Neither was about to launch an attack, although both feared that one was coming.

In the case of China and the U.S., the Chinese interest is to maintain its essential economic relationship with the United States and to avoid triggering a naval conflict off its shores, while retaining its right to navigation. For the United States, the imperative is to develop a trade relationship that fits current realities, which are different than those of 30 years ago, and to maintain a pro-American stance on the archipelago east of China (namely, Japan, South Korea, Taiwan, the Philippines and Singapore) to preserve American control of the Pacific.

Not everything China and the U.S. do is directed against each other, although they will believe it is. Geopolitics lays out the red lines that can’t be crossed. And that reality will not emerge from speeches and articles, even those given by high-ranking officials.