Why Trump’s America is rethinking engagement with China

The more aggressive US approach is part of a strategic shift that goes well beyond the trade war

Demetri Sevastopulo in Washington

© Reuters

When Donald Trump sat down to dinner with Xi Jinping last month at the G20 summit in Buenos Aires, the US president did not know about the diplomatic bomb that was about to explode. At about the same time, police in Canada arrested a Chinese telecoms executive after an extradition request from Washington.

The detention of Meng Wanzhou, chief financial officer of Huawei, was extraordinary because the US justice department had not told the White House about the warrant to arrest the daughter of the founder of the telecoms group, one of China’s most successful and influential companies.

But the importance of the arrest went well beyond the immediate circumstances. It is the most striking symbol yet of the dramatic deterioration in relations between China and a US that is increasingly suspicious of Beijing’s motives and actions. Reinforcing the rupture, the US several weeks later charged two Chinese nationals with conducting a global hacking campaign to assist the Chinese intelligence services.

Huawei CFO Meng Wanzhou was released on bail while she awaits a hearing on extradition to the US © AP

While the trade war has received the most attention, the economic tussle is part of a much more profound shift in the US that has seen Washington reverse important elements of the strategy of engaging with its Asian rival that was first introduced more than 40 years ago by Richard Nixon.

Support for this change in approach has a broad base in the US. Officials across the US government have become significantly more hawkish towards China— over everything from human rights, politics and business to national security. At the same time, US companies and academics who once acted as a buffer against the harshest views are now far less sanguine.

“China has for some time underestimated the extent to which the mood in the US has shifted,” says Hank Paulson, the former US Treasury secretary. “The attitude that they would implement reforms at a timetable that made sense to them missed the fact that this was no longer sustainable if they wanted the US to keep its markets open to them. And the US business community now supports a harder line.”

Former US Treasury secretary Hank Paulson: 'The mood in the US [on China] has shifted' © Bloomberg

While Mr Trump likes to describe China’s president Mr Xi as his friend, his White House signalled a major shift away from China when it labelled the nation a “revisionist power” in its December 2017 National Security Strategy. In October, Mike Pence, vice-president, hammered home that message in a speech at the Hudson Institute that charged China with a litany of offences — from political repression at home to coercive diplomacy abroad.

The rhetoric has been matched with action. In the South China Sea, the US navy is now conducting frequent freedom of navigation operations to push back against Chinese sovereignty claims over disputed reefs and islands. Meanwhile, the justice department created a “China initiative” task force to crack down on espionage.

While Ms Meng was arrested for allegedly helping her telecoms company violate US sanctions on Iran, US officials have long worried that Huawei could help China spy on rivals. Those concerns escalated last year, culminating in the US convincing its Five Eyes intelligence-sharing partners — Canada, Australia, New Zealand and Britain — that they needed to take a much tougher line on Huawei, according to one person familiar with the situation.

Donald Trump likes to describe Xi Jinping as his friend, despite the escalating rhetoric © AP

While concerns about China have risen in parallel with its emergence as a rival to the US, Washington has concluded that it has underestimated the speed at which it has caught up with the US in terms of technology — particularly technology with military applications.

Dennis Wilder, former head of China analysis at the CIA, says that as the US war on terror has receded in urgency, intelligence and national security officials have now woken up to the fact that China was using a “whole-of-society” approach to collecting intelligence, and that the openness of the west to Chinese scientists, students and business people had become an “Achilles heel”.

“The Chinese intelligence operations were astoundingly successful in providing the military and other state-owned enterprises with the secrets to enable technological leaps that could only be possible with the theft of advanced critical technology from the US, Japan and Europe,” Mr Wilder says.

Mr Trump and his trade war have done a lot to change the mood but many experts say China would have faced a harsher climate regardless of whether he had won the 2016 election. One of the few areas where Democrats and Republicans are united is over the need to adopt a tougher stance towards Beijing.

Lindsey Ford, a former Pentagon official under Barack Obama, says US military officials started to become much more concerned about China in the second half of his administration, when it appeared that Mr Xi was abandoning the “hide and bide” low-profile approach espoused by former leader Deng Xiaoping.

This was most striking in the rapid land reclamation in the South China Sea, where it installed weapons systems on some islands despite Mr Xi having pledged to Mr Obama in 2015 that China had “no intention to militarise” them.

Ms Ford says the South China Sea activity was “the clearest signal that the game seemed to have shifted and that China’s own calculations about how much risk it was willing to accept . . . was no longer the same”.

At the same time that its navy has become more assertive, China has developed weapons-related technologies at a much faster pace than many US analysts once thought likely.

Underscoring how the gap between the US and China has shrunk, General Paul Selva, vice-chairman of the joint chiefs of staff, warned in June that “if we sit back and don’t react, we will lose our technological superiority in 2020”. The Pentagon is also concerned about the vulnerability of its military supply chains because of components made in China.

Donald Trump and Xi Jinping at a state dinner at Beijing's Great Hall of the People in November 2017

Washington is raising red flags about activities aimed at stealing US technology — whether via Chinese nationals working in American university labs or cyber espionage. One person familiar with the situation says US officials realised how much more vigilant they needed to become when they discovered just how much similarity there was between the Chinese J-20 stealth fighter jet and the American F-35.

To tackle the threat, the US has significantly stepped up the vetting of Chinese nationals who apply to study sensitive subjects in America. Christopher Wray, FBI director, last year warned Congress that US universities were naive about the potential for Chinese nationals to collect intelligence on their campuses.

John Demers, head of the justice department’s China Initiative, recently told the Senate judiciary committee that 90 per cent of economic espionage cases over the past seven years involved China. When the US charged the hackers in December, it said Beijing had breached a 2015 deal that neither nation would steal intellectual property for commercial advantages.

John Demers, assistant attorney-general for national security at the justice department, says 90% of economic espionage cases against the US in the past seven years have involved China © Bloomberg

The US is also concerned about China trying to recruit American spies. In his testimony, Mr Demers said the justice department had an “unprecedented” three cases against former US intelligence officers accused of spying for China. In May, the US charged a former CIA operative named Jerry Lee with illegally possessing secret information.

The CIA believes he provided Beijing with details about its spying operation in China. One person familiar with the situation says his actions dealt a catastrophic blow to the CIA’s network — as many spies were arrested or executed.

The US also believes that two suspected Chinese cyber attacks — one in 2015 on the Office of Personnel Management which maintains government employee records, and another later on the Marriott hotel group — were part of an operation designed to help China identify covert US intelligence operatives in the country.

As the US strikes a tougher tone, China is losing constituencies that once helped balance the more hawkish views in security circles. US academics who were seen as friendly to China are becoming warier as Beijing cracks down on human rights — such as the mass detention of Uighurs in Xinjiang, failures to follow through on economic pledges, pressures on US scholars to toe the party line and moves backwards in terms of political reform.

“People I’ve known for decades have given up on China,” says Susan Shirk, chair of the 21st century China Center at the University of California San Diego. “There’s a widespread view in the academic community that the overreaching China has done both domestically and internationally is hard-baked into the system and that there’s no hope of getting them to adjust their behaviour to our interests and values.”

Mike Pence, US vice-president, has hammered home the American message that China is a 'revisionist power' © AP

A turning point that alarmed Washington came in late 2017 when Mr Xi did not name a successor at the Communist party’s 19th congress. He also pledged that China would become a fully modern economy by 2035 — picking a date that some saw as another sign that he intended to remain in power following his second five-year term. In a further sign of centralising power, the National People’s Congress approved last March a change in the constitution to remove the two-term limit on the presidency.

More recently, Mr Xi reignited concerns that he was moving backwards on promised reforms when he used a speech commemorating China’s economic opening 40 years ago to stress the primacy of the party. “No one is in a position to dictate to the Chinese people what should or should not be done,” he said in December.

One senior US administration official says China has misread the change of mood in the US, adding that “even more disturbingly, they just don’t care”. The official says the fact that Mr Xi’s speech had focused on “the growing role of the Communist party in every aspect of economic, political and personal life in China” suggested that Beijing was not taking the US concerns seriously.

The American F-35. China's J-20 stealth fighter has a similar specification © Getty

“I don’t see signs of a course shift by the top leadership,” says the official.“I never thought China would aspire to be a Jeffersonian democracy or espouse the western liberal order,” says Mr Paulson. “I always thought the Communist party would be paramount, but I didn’t see the clock being turned back.”

Ms Shirk says a major reason for the growing US backlash is that the business community has “really soured on China”. “Right now, it is totally out of balance because the national security concerns are completely dominating the process and the business community isn’t resisting,” she says.

Ryan Hass, a former White House official now at the Brookings Institution, says many US companies had “promise fatigue”. While many did not agree with the approach Mr Trump was taking on trade, they wanted him to be tough on China on market access and were “trying to use Trump’s instincts for disruption [to] their advantage”.

“The Chinese leadership has promised for years that reform was around the bend and then you see things like President Xi’s speech where he emphasised the central role of the party,” says Mr Hass. “Members of the business community see the Trump administration as an opportunity for the US to rattle the cage in Beijing.”

Former state department official Susan Thornton says the wider relationship with China is being ignored inside the administration © Bloomberg

Susan Thornton, the top Asia official at the state department until last summer, says many of the grievances had existed for years but Mr Trump was giving them impetus because there was no one inside his administration who was weighing those concerns against the broader China relationship.

“There is no one imposing discipline right now. Everybody has now got a hunting licence. It is open season on China,” says Ms Thornton. One reason the Chinese may have been blindsided by the changing US approach is that Mr Trump rarely raises security issues. “Trump never brings up any of that stuff in meetings with the Chinese,” she says. “He won’t bring up Taiwan or the South China Sea, or nuclear missiles or arms control, or espionage.”

Just before New Year, Mr Trump tweeted that he had spoken to his Chinese counterpart and that there had been “big progress” on trade. But the landscape has changed so dramatically that most China experts believe the relationship will become much more rocky even if there is an agreement on trade.

“I am cautiously optimistic that President Trump will be able to declare a trade victory and end the tariff war,” says Mr Paulson. “But there will still be so many intractable economic and security issues that this will continue to be a very fraught relationship.”


How the Blockchain Ushers in a New Form of Trust

Blockchain is one of the biggest buzzwords in technology today. But confusion exists about what it is exactly: The blockchain is often mentioned in the same breath as bitcoin and other cryptocurrencies, but it encompasses far more than that.

Kevin Werbach, Wharton professor of legal studies and business ethics and a blockchain expert, has written a book that explains this technology with great depth and precision. For example, he points out that bitcoin refers to the cryptocurrency, while Bitcoin comprises the bitcoin network.

He recently spoke with Knowledge@Wharton about his book, The Blockchain and the New Architecture of Trust. Following is an edited transcript of the conversation.

Knowledge@Wharton: What got you interested in bitcoin and the blockchain?

Kevin Werbach: I study emerging technologies. I’m a legal scholar by training, but I’m interested in internet-related technologies that have significant business impacts. And like many people, I first heard of bitcoin several years ago, when it was still very small, and found it fascinating.

This idea that it was possible to create money — something that stored value in a decentralized way — and that it actually worked, that people would actually trust it as being valuable, I found tremendously interesting. But it was only when the whole blockchain space developed and became a broader business environment a few years later that I really started to increasingly focus my research on this area.

Because really, blockchain is a fusion of law, business, technology, economics — all these different areas where I have some expertise, and where I think there are really potentially huge opportunities to create new kinds of organizations and new kinds of [businesses].

Knowledge@Wharton: One thing about your book that struck me was that it makes a great effort to be precise about a topic that confuses many people. So, perhaps we could start with your explaining the difference between bitcoin and the blockchain.

Werbach: This is important. One of the reasons that I wrote the book was because I was speaking to many people — senior business executives, policy makers, and others — who were smart people, tech-savvy people, who would say to me, “I just don’t get this blockchain thing.” And so, I tried to write something that was a deep, substantive treatment of the issues. It goes into legal questions and policy questions, but that starts with articulating for a broad audience what’s going on here.

The first piece of this is that there are actually several different related phenomena. Bitcoin was the first piece to come on the scene. The bitcoin white paper was released on Halloween in 2008, and the Bitcoin network started operating in early 2009. So, it’s about a decade old now.

Bitcoin is a private digital form of money. So, the idea with bitcoin was: Can we create something that has the same functions as money — which means people trust that it’s still valuable, it can be used as a means of exchange, or a store of value, or a unit of account in theory — without a central entity issuing it, or validating transactions?

That was really the starting point for the whole blockchain space. Although it turns out that, when you look at bitcoin technically, it was actually based on, in many cases, earlier work that had been done in related areas, which has now been used in some of these implementations other than bitcoin.

Knowledge@Wharton: The blockchain is the technology underlying bitcoin, and that’s what makes it different?

Werbach: Bitcoin is what’s called a cryptocurrency. And a cryptocurrency is basically a token of value on one of these decentralized networks. The broadest term for the decentralized networks is Distributed Ledger Technology, or DLT. And that encompasses a whole wide range of things.

On the one hand, [we have] what are called permission-less, open systems like bitcoin — there are now something like 1,600 other cryptocurrencies that are out there, although most of them are not particularly used or valuable — and these allow anyone to be on the network. Not only can anyone make a transaction, but in most cases, anyone can be a validator, can be in the role of verifying the transactions are accurate. And what’s extraordinary is that these technologies make it trustworthy to have this system, even though anyone can be on the network.

That’s the cryptocurrencies. And they’re based on these underlying networks called blockchains. And blockchain is basically a family of technologies for ordering transactions, for having a decentralized kind of database where there’s not one actor that controls it, where multiple parties are in control.

But there’s still confidence they’re all seeing exactly the same thing. The network comes into what’s called ‘consensus.’ So, at any moment, it’s possible to be confident that we all see the same information — the same transactions in the same order. For something like bitcoin or a cryptocurrency, that means we all see the same balances of money in our accounts. But it’s much broader.

Knowledge@Wharton: A lot of people think that, when you talk about the bitcoin blockchain, it’s really a system that doesn’t need trust. But instead, you’re arguing that the blockchain actually represents a new form of trust. 
Werbach: That’s one of the key mistakes that I see people making. And again, one of the things that motivated me to write the book was I saw all these conversations in the blockchain and cryptocurrency world talking about this as a trustless technology. And the idea was that, well, trust is dangerous. If we trust someone, they could abuse our trust. They could take advantage of us. We see that with private companies.
For example, people stored their data with Equifax, and their data was stolen, so they trusted something untrustworthy. Or Facebook, which has had all of these issues with Cambridge Analytica and privacy breaches, and so forth. That’s part of the concern. So the argument is, let’s get rid of trust. Let’s have a system where we don’t have to trust anything except just the technology. And we can look at the code, and it’s based on cryptography, which is mathematical information security. And that’s all we need.

The point I’m making is that, even if that’s true, and I think that is true, and these cryptocurrencies and blockchain systems have been able to develop robust trust in the ledger itself — in the fact that this asset went from this person or this cryptographic private key to this other one — it takes more than that to have trustworthy transactions. You need to trust the system as a whole, because there might be abuses.

You don’t necessarily know who you’re dealing with. There are other parties that are involved in that validation process, in developing the code, and so forth. And there are all kinds of situations where, even if people aren’t bad actors, there are disputes. And you need some way to resolve the dispute. So, the argument that I make in the book — and it’s basically the title — is that blockchain is not the end of trust. Blockchain is a new structure of trust, what I call a ‘new architecture of trust’ that recreates trust in a different way.

Knowledge@Wharton: When people hear the words ‘trustless system,’ the connotation is that it’s a lawless system. And I think in your book, you say that it’s exactly the opposite. Is blockchain compatible with the law?

Werbach: It’s absolutely compatible with law. But it doesn’t embed law in its native state. Absolutely, these blockchain networks can and are used in some cases to engage in illegal activity. People use bitcoin to engage in money laundering, to buy illegal drugs, and so forth. Now, it turns out that law enforcement, in many cases, has an easier time tracing that on the bitcoin network than on traditional financial networks.

When I go and make a cash transaction — cash is a true bearer instrument — it’s hard to trace. Whereas with bitcoin, it’s a public network. All the transactions are public. You just have to associate that cryptographic private key with a human person or entity. And it turns out that there are a variety of sophisticated ways to do that.

There is this illegal activity. There also is fraud going on. For example, there are what are called Initial Coin Offerings, where companies offer these tokens for fundraising. There’s a ton of scams and fraud in that world. The point I’m making is there’s nothing inherent in the technology that will necessarily cause it to be used for illegal activity. And in fact, there’s a vast amount of legitimate legal activity happening.

Businesses are deploying on blockchain technology because they see it solving real business problems. The challenge is how to safeguard and promote the legal activity and minimize the illegal activity and do it in a way that doesn’t create too much friction in the process. That requires, unfortunately, a fairly slow and at times cumbersome process of figuring out how to put blockchain together with law, regulation, and governance. [I spend a lot of effort in] the book outlining how that process actually works.

Knowledge@Wharton: How should regulators approach the blockchain? You mentioned in the book three questions they should ask to determine whether or not to act.

Werbach: First of all, the regulators need to ask, “Is this a system that’s designed for legal or legitimate purposes?” There are bad actors out there. There are systems that basically make it harder to track transactions and make it easier to engage in illegal transactions, where that’s the point of the system. We saw this 20-odd years ago with peer-to-peer file sharing, with systems like Napster and so forth, where they were services that clearly were designed to facilitate copyright infringement. They were shut down.

Then there were other systems that use very similar technology. BitTorrent is a good example. The company that makes BitTorrent — which for a while was a huge percentage of traffic on the internet because it was used for sharing video — was never sued successfully. It was never shut down by the government because it built a technology that was really valuable, actually, for companies wanting to share media files, and did what it could to limit the illegal uses. So, the first question is, who’s behind this? And what are the indications about whether they see the potential illegal uses as the goal, or something that they want to work on minimizing?

The second question is, what are the mechanisms of achieving the government’s purpose? People in technology — entrepreneurs and people like advocates of cryptocurrencies — often think that governments regulate because they want to control things. I used to be a regulator. I was at the Federal Communications Commission early in my life. Governments generally don’t do that. They regulate because they want to address their objectives, serve their missions.

If your mission, for example, is to combat money laundering and terrorist financing, and using money to facilitate crime, then you’re going to want to come up with a system that does that. So, the question is, what are the mechanisms governments can use? As I said, in the case of things like bitcoin, it turns out that governments can actually track the transactions on the blockchain, as opposed to preventing the transactions from happening when those could be legitimate transactions. So, the second question is, what are the alternatives for meeting the government’s need?

The third one is cost and benefit. There are huge benefits, directly, in terms of having regulation to prevent people from losing their money, and [to curb] illegal activity. But there are also broader benefits to the blockchain community. It comes back to trust. We need a trustworthy environment where ordinary people and existing companies are willing to commit their money and commit their resources to this exotic, weird, decentralized new technology. It has to be trusted. Regulation actually can play a good role there.

Regulation also has costs. It can be over-broad. It can limit innovation, and so forth, if it’s not designed well. Regulators need to think hard about those costs and benefits. I think if they ask those three questions together, they’ll be well-positioned.

Knowledge@Wharton: Let’s move on and talk about the potential of the blockchain. How do you think blockchain technology can be used pragmatically today, or in the near future? How do you see it being adopted?

Werbach: There are three buckets of adoption that I see. One is cryptocurrencies, which is the most radical, but also the least mature part of this world. And that’s either using something like bitcoin as a substitute for money or using these cryptocurrency tokens to power decentralized applications because basically, a blockchain is a kind of distributed computer and it’s possible to [have] applications — just like we have applications running on the internet — running on these decentralized ledger systems.

The power there is potentially, they’re not controlled by any entity. The platforms are not under the control of very powerful intermediaries who have an incentive to bias the system, and to pull back the value to themselves. That’s an area where there’s a huge amount of fascinating experimentation. People may have heard of things like CryptoKitties, where there are games that are being built on it, and real applications. But it’s still very, very early — technically very early in terms of adoption.

The second bucket is the blockchain — the ledger solutions, which are about tracking things. Any time there are multiple organizations that have to work together on some business process, who don’t fully trust each other, there’s a cost, right? Because they have duplication of information. Each wants to keep its own copy of information. They have to reconcile and settle. And you add this up across the entirety of global business, it’s trillions of dollars that are lost in these processes.

Blockchain, by creating a virtual ledger — a shared source of truth across organizations — can provide value in a massive range of these applications in pretty much every industry you can think of. In that second category, there is a fair bit of adoption. There are companies that are doing real productions systems — there’s one consortium I talk to called Hyperledger that has 50 production networks operating on its technology, and that’s just one platform — which are the actual systems of record between real companies. But in most cases, it’s still fairly early. The volumes are still fairly small. But it seems to be coming.

In the third bucket are what I call ‘cryptoassets,’ which is the one where there’s actually the most economic activity, because it’s the least radical. This is basically Wall Street and the financial system using these as tradeable assets, saying, basically, if I’ve got a cryptocurrency like bitcoin or some other token, and there’s a … sufficient confidence that it is a legitimate store of value, it’s a native digital asset. It’s something that can be securitized, that can have rights and responsibilities, can be the basis for derivatives, can feed into this massive global financial transactional system that we have.

That’s actually the area where, over the last year, there’s been the most activity, and I think where we’ll see the most financial transactions in the near term. It requires a little bit of legal clarity. It requires a little bit of building interfaces and middleware systems, which is happening, but it doesn’t have to change the basic structure of the marketplace. And so, in that area, we’re seeing real interest by institutions and traditional sources of capital. Because again, it’s a more efficient solution for what they were already doing.

Knowledge@Wharton: You write in the book that blockchain could change the world, but, and this is a quote from you, “crucially, how and when remain uncertain.” What do you mean by that?

Werbach: That’s always the question with transformative technology, right? Anything that is deep enough and significant enough to potentially affect global business is not something that’s going to be a light switch. It’s not something that’s going to happen overnight. And it’s not something where it’s going to be uniformly adopted because there are costs. Because this requires people to think about doing things differently. And there are going to be losers in the move to this new system.

If you think of blockchain just as a way to speculate in these tokens, or you think about it as an alternative form of money that will only succeed if it replaces the traditional fiat currencies, then I think you’re missing the big picture. The real revolution is seeing this at a deep level as a new structure for trust. And when you look at where trust is important in business, it’s everywhere. But because it’s so broad, that means it’s going to be a long, unfolding process where we don’t know what the killer apps are.

I gave you a model of three buckets. But specifically, where is this going to be adopted, what countries, what parts of the world, what industries are going to move first — in hindsight, it will all be obvious. In hindsight, we’ll say, “Yeah, that’s the killer app.” Of course, you would buy books on the internet. And then of course you’d buy everything on the internet on Amazon. Of course, advertising was a way to monetize search into this massive tens-of-billions of dollars industry. I can tell you, at the time, none of those things were obvious. And people were skeptical of all of those claims. So, it’s a similar sort of thing. Because the potential is so great here, that’s why there’s so much uncertainty about exactly what the path forward looks like.

Knowledge@Wharton: It’s been almost a decade since the bitcoin white paper came about. And cryptocurrencies are very popular obviously, but you don’t see the blockchain adoption reaching a stage of maturity that perhaps one would expect. So, in your view, based on your research and experience, is the blockchain really a revolution?

Werbach: We’ll see. I think some aspects of it are clearly revolutionary. Whether it will actually be a successful revolution, that’s the open question. I’m very confident at this point it’s not going away. It’s going to be widely adopted, and just integrated into the fabric of business, just as many internet technologies have been. We sort of take them for granted now. But it took a long time, with many challenges, to get to the point where they were moving into all of these different companies all around the world in a deep way.

I think you somewhat have to choose. If you want the revolution, that’s really exciting. But it also reduces the likelihood it’s going to happen. I don’t, for example, think that bitcoin or any other cryptocurrency will subsume or replace dollars and the existing currencies we have. I think actually what’s going to happen is the major governments like the American government — and probably sooner than that, the Chinese government and many of the others — will tokenize their currency. They’ll use the blockchain technology in a permissioned way to digitize their fiat currency. Is that a revolution? In some ways, absolutely. It’s not the same revolution as we’re all going to be buying things in bitcoin. I think there’s still a place for bitcoin and the other cryptocurrencies, but maybe not as much of a sweeping revolution as people think in that vision.

Look, it depends on whether you’re focused on true disruption of the way things are done, which very rarely happens. When it does happen, it has huge costs as well. Or are you saying, what’s going to be important? What’s going to actually affect business across the board to the point where, 10 years from now, no one could ignore it? … I think that latter [scenario] is where blockchain is going. And if that’s not a revolution, fine with me.

Wary investors drawn to gold’s allure

Central-bank buying pushes prices higher after two tough years for gold bugs

Henry Sanderson and Neil Hume

Gold has been boosted by the expectation that the Federal Reserve will hold off from interest-rate increases this year

If gold is anything to go by, investors are increasingly anxious about the state of the world.

Volatile equity markets and fears of a global economic slowdown have helped gold rally 10 per cent from its August lows, putting it among the best performing metals over that period.

It is a sharp contrast to much of the past two years, when rising US interest rates, a strong dollar and buoyant equity markets hurt gold bugs and the shares of miners such as Barrick Gold, Newmont Mining and Goldcorp. And when there was a correction in US stocks in early 2018, the gold price failed to benefit.

Almost a year on, the big question is whether 2019 could prove a profitable year to own gold, which is typically bought as hedge or haven by investors.

The amount of physical gold in exchange traded funds has risen to 71.9m ounces, close to the record high of 72m touched in May 2018.

“We haven’t seen flows like this since the first half of 2016 — when the gold market really took off,” says Joe Foster, a portfolio manager at VanEck in New York.

“There seems to be a change in sentiment and investor psychology. People are waking up to the fact that we are late in the economic cycle and we could be ending [it] in the next year or two. That brings more risk into the system; that’s why gold is moving up.”

Those flows, along with investors covering their bets against gold, have helped the yellow metal’s price recover from the 18-month low of below $1,200 a troy ounce touched last August.

Analysts say there are a number of reasons to think the gold price can break through the $1,300 mark and push higher.

These include still-fragile stock markets, the expectation that the Federal Reserve will hold off from interest-rate increases this year, and a weaker dollar, which makes the metal more appealing. Rising US rates have been a drag on gold since the metal provides no yield.

Goldman Sachs, one of the most influential banks in commodity markets, raised its gold forecast last week and now expects a gold price of $1,425 over the next year.

“To take a view on gold, you have to first take a view on broader markets,” said Tom Holl, BlackRock portfolio manager, natural resources. “If we continue to see elevated levels of macroeconomic uncertainty and risk adversity, then gold will probably continue its positive momentum.”

Some investors believe rising concerns over US debt levels could sharpen gold’s allure, according to John Hathaway, a senior portfolio manager at Tocqueville Asset Management in New York.

Last week, Fitch Ratings warned that a continued government shutdown in the US could lead to a credit downgrade on the country’s debt, which is rated AAA by the agency.

“The US is beginning to sport a debt-to-GDP ratio worthy of any banana republic,” says Mr Hathaway. “We believe that exposure to gold is both timely and potentially rewarding.”

Higher levels of debt will also make it hard for the Fed to raise rates and tighten monetary policy, adds Trey Reik, a senior portfolio manager at Sprott Asset Management in Connecticut.

“I do think the dollar is in the midst of a long-term weakening,” he says. “You cannot raise rates with that much debt in the system without causing economic collapse.”

The buying of gold by central banks is also at its highest level since 2015, as many authorities remain keen to diversify away from the dollar.

Standard Chartered estimates that central banks bought 500 tonnes of gold last year. China was among the buyers, adding almost 10 tonnes, following more than two years of unchanged holdings.

“While Russia, Kazakhstan and Turkey dominate central bank purchases, a host of other central banks entered the official sector gold market last year,” says James Steel, chief precious metals analyst at HSBC.

Mr Steel notes that the list includes Hungary, which had been out of the gold market for decades, with the exception of modest purchases in 2017. The central bank of Poland also purchased gold for the first time in many years, he adds.

However, the multiple disappointments for gold bulls over the past year leave some wary. Gold has not breached the $1,300 level since June.

While ETF holdings have risen to their highest level in five years, traders in the futures markets have not yet placed significant bets on higher prices, according to ICBC Standard Bank, a unit of China’s largest lender.

“On the one hand this does present an opportunity for gold prices to move higher still, if investor length now comes into the market,” says ICBC analyst Marcus Garvey.

“However, on the other, it begs the question as to why this has not yet happened, given the number of catalysts already present. If any of the recent tailwinds for gold were to abate, it increases the likelihood for a period of price consolidation.”

The World Is Drowning in Debt

By Reshma Kapadia 

The World Is Drowning in Debt
Joel Arbaje; Source Photograph by Bill Jelen

There is much they quarrel about. But there is one thing most investment strategists and economists can agree on: The world is drowning in debt.

Global debt has grown to $244 trillion—three times the size of the global economy—according to the Institute of International Finance, a Washington, D.C.-based organization representing the global financial industry, which just released a report on debt. A rapid buildup in household debt in China and other emerging markets, and a record amount of debt coming due in the next two years, are high on the group’s list of concerns.

Global debt has grown 12% since interest rates started rising and hit 318% of global gross domestic product last year, up from 170% in 2000, according to the IIF. Two of the biggest sources of the increase: developed market governments that borrowed rather than paid down deficits during the global economic recovery, and emerging market companies that took advantage of investors eagerly willing to lend to them in return for yield. Now, higher interest rates and slowing growth makes all that debt more burdensome.

Here are some of the ways to think about the global debt load and what investors should be most concerned about.

Household debt in emerging markets. As emerging market countries continue to develop, it’s natural for household debt to pick up. But there has been a sharp rise in household debt as a percentage of GDP in emerging markets since 2016 as the U.S. Federal Reserve was raising interest rates. Such debt has risen 30% since 2016 to $12 trillion, with China accounting for half. Other countries with sharp increases: India, Mexico, Korea, Malaysia, and Chile. The debt can be a drag on consumption and for capital markets if sentiment sours, Emre Tiftik, deputy director of the IIF’s Global Capital Markets, said on a conference call Tuesday.

Dollar-based liabilities for foreign banks. This one falls into the one-to-watch category. While many banks do a lot of business in dollars, the concern here is the gap between dollar-based liabilities and dollar-based assets for European and Japanese banks, with $13.3 trillion in dollar-based liabilities at foreign banks. For example, Japanese banks are looking at a roughly $800 billion gap between their dollar-based liabilities and dollar-based assets. If the dollar strengthens significantly or there is more tightening in monetary policy, that could lead to problems. “It needs to be monitored more carefully. During stress episodes, dollar-funding becomes a key driver of sentiment,” Tiftik said.

China. In 2017, the country’s efforts to reduce the debt that had helped its rapid growth could be seen in the data. But in 2018, corporate borrowers in China started to increase their debt, suggesting they were focusing elsewhere. Does that suggest China is failing in its deleveraging push? “No, it’s more of a shift in emphasis,” Sonja Gibbs, managing director of Global Policy Initiatives at the IIF, said on the conference call.
Redemption time. A record $3.9 trillion of emerging market bonds and syndicated loans comes due through the end of 2020. Most of the redemptions in 2019 will be outside of the financial sector, mainly from large corporate borrowers in China, Turkey, and South Africa. The question will be if they can refinance the debt. The IIF doesn’t see a crisis, but does note that these companies will have to refinance the debt at a higher cost, hurting their growth prospects.
This is one reason emerging markets are so sensitive to whether the Federal Reserve is leaning toward a more dovish or hawkish stance. Higher rates makes this debt costlier to refinance.

Contagion. Concerns that the troubles in Argentina and Turkey would ripple across emerging markets loomed over investors last year. The IIF doesn’t see a systemic crisis, but does see more trouble ahead in places where debt buildup has been especially rapid, such as Saudi Arabia, Lebanon, and other Middle Eastern and African countries that could be hit hard as debt comes due at a time of slower global growth and higher rates. Another potential wild card that could complicate the refinancing: oil prices.

The uncertainty about the direction of capital inflows casts doubt over whether emerging markets borrowers can service and manage debt. Plus, high debt levels divert resources from more productive investments, casting a pall over long-term growth, Gibbs said.

After losing 5.5% in 2018, the iShares J.P. Morgan USD Emerging Market Bondexchange-traded fund (EMB) has had a reprieve, up almost 2% so far this year. But if the latest debt statistics are any indication, that calm may belie more volatility ahead.