How the US should deal with China

Washington is in danger of throwing away the leverage its allies could have given it

Martin Wolf

                                                                                                                                  © James Ferguson

“It’s easy to win a race when you’re the only one who knows it has begun.

China is thus on the way to supplanting the US as the global hegemon, creating a different world as a result.

Yet it doesn’t have to end this way.”

This anxious view comes from The Hundred-Year Marathon by the Hudson Institute’s Michael Pillsbury.

Mr Pillsbury is one of the most influential American thinkers on US-China relations.

The book is more than a call to recognise reality: it is a call to arms.

On one central point Mr Pillsbury is certainly right: China’s rise is the great political event of our times.

Getting the response right is crucial. It is so easy to get it wrong.

Today, I fear, the US is getting it frighteningly wrong.

The starting point must be that, whether or not China has a plan for world economic domination by 2049 (the 100-year anniversary of the creation of the People’s Republic), that is a plausible, though not inevitable, outcome.

Other things being equal, population is decisive in determining the size of an economy.

The US is the most powerful high-income country because it has the biggest population, by far.

But the population of China is to the US’s, roughly what America’s is to Germany’s.

Nobody could now imagine a world in which Germany’s economy is comparable in size to that of the US.

Similarly, why should we imagine that the US economy will remain indefinitely comparable in size to that of China?

There can only be one answer to this question.

US output per head will remain far higher than China’s, permanently.

At market prices, China’s gross domestic product per head in 2018 was just 15 per cent of US levels.

That is very close to Turkey’s (and ranks 72nd in the world).

Imagine, however, that China achieves Spain’s output per head, relative to the US.

Its economy would then be twice the size of that of the US, at market prices (and close to three times as big in terms of purchasing power).

Is it plausible that China will, over the next three decades, achieve a GDP per head relative to the US comparable to that of Spain today?

Of course it is.

Does anybody doubt that the Chinese people are capable of this?

But what is plausible is not inevitable.

It is possible, instead, that Xi Jinping will be remembered as China’s Leonid Brezhnev.

Brezhnev closed down all thoughts of economic and political reform in the Soviet Union from 1964 to his death in 1982.

He emphasised communist orthodoxy and party discipline.

The result proved a disaster for the USSR.

His conservatism bore direct responsibility for the subsequent collapse.

It is conceivable that Mr Xi’s re-establishment of party discipline and the role of the state in economic life will have similar consequences for China.

But what is conceivable is not inevitable.

China also has a vigorous market economy and a studious bureaucracy.

It may avoid this trap.

In sum, what Mr Pillsbury views with horror is not just plausible, but natural.

What, short of war, could the US do to stop it?

The answer is: not much.

Yes, it could halt its imports from China and try to halt all transfers of technology, too.

Such actions would hit China’s development, but they are unlikely to halt it.

Only Chinese blunders, always possible, are likely to do that.

This is a cry not for defeatism, but for the realism Mr Pillsbury himself calls for.

China is likely to become the world’s greatest economic power because it is both big and competent.

Yet even if the US does not remain the world’s largest economy over the decades ahead, it should retain three significant assets: a law-governed democracy; a free-market economy; and economically powerful allies.

These are sources, respectively, of admiration, dynamism and strength.

Unfortunately, the US is trashing them all.

President Donald Trump seems ignorant of what a liberal democracy is.

The US economy is slowly morphing into rentier capitalism.

It has also become an unreliable and even outright hostile ally — ask the Germans.

The last might be the biggest blunder of all.

For military strength, the US has in truth to rely mainly upon itself.

But in economic policy or human rights, it does not.

The US’s allies bring enormous extra weight to the table (unlike Russia, China’s only potent ally).

Take trade: China’s exports to close US allies far exceed those to America alone.

Many of those allies also share US concerns over market access, poor protection of intellectual property and China’s demand to be treated as a developing country.

Yet the US has thrown away the leverage its allies could have given it.

If it had promoted a negotiation with China inside the World Trade Organization on these issues, in concert with its allies, it would have enjoyed both more leverage and the moral high ground.

It is, of course, not enough for the US to appreciate its resources.

It also has to know what to do with them.

It is not to make itself an enemy of the Chinese people’s legitimate desire for a better life.

Still less is it to dream of overthrowing China’s political system.

Such aims are neither reasonable nor achievable.

It is to stand up for an open and dynamic world economy, based on market principles, to defend freedom of speech and to challenge abuses of human rights in China itself.

But it is also to recognise that, if humanity is to achieve economic progress, maintain peace and preserve the global commons, a high degree of co-operation must also exist between the superpowers.

In dealing with China, the US and its allies need to confront, compete and co-operate across multiple domains.

Today, this seems inconceivable.

Instead, we are looking at a crumbling alliance and a fraught relationship between the US and China.

None of this augurs well for humanity’s future.

Remember: it could be so much better.

Inverse psychology

America’s yield curve is no longer inverted

So, no need to worry about recession? Hmm, maybe

WHAT DO YOU get when you subtract the yield on short-term government bonds from that on longer-dated ones?

A powerful economic omen, if recent history is any indicator.

Around a year before each of the past three recessions the yield curve—which shows the return on government bonds from very short durations to very long ones—inverted.

In July 2000, for instance, the yield on ten-year Treasury bonds dropped below that on three-month Treasury bills; by March 2001 the American economy had sunk into recession (see chart).

When the same thing happened in March this year, alarm bells rang across corporate boardrooms and political campaigns.

When the inversion deepened over the summer, traders and pundits began to speak of recession as a real possibility.

Now, however, the curve has righted itself.

From mid-October, long-term bond yields rose back above short ones (a move accompanied by other bullish financial-market signs, like rising stocks).

Market-watchers are asking: was that a false alarm?

Few economists think a yield curve inversion itself causes a slowdown.

The link between the two has more to do with the effect of monetary policy on both.

Short-term bond yields go up when the Federal Reserve raises its policy rate to keep the economy from overheating.

A drop in long-term yields often occurs when markets expect slower growth ahead: a sign that the Fed has tightened a step or two too many, hitting the brakes hard enough to drag the economy into recession.

This time around, the Fed seemed to take the omen seriously.

Over the course of 2019 it has first abandoned plans to keep raising rates (which had been going up since 2015), then cut its policy rate three times, reducing the effective rate from 2.4% or so to 1.55%.

The yield curve was not the only thing on the mind of its chairman, Jerome Powell: cuts were also a response to a deepening slump in manufacturing and a plateau in the growth rates of prices and wages.

But the central bank nonetheless responded faster and more fiercely to an inversion than it usually had.

If rate reductions have in fact spared the American economy from recession, then Mr Powell, by reacting promptly to the yield-curve omen, may have actually weakened its predictive power.

Few workers, or presidents, are likely to complain.

But the coast is not yet clear.

The Fed might yet seize defeat from the jaws of victory.

Rather than recognising its own success, it could interpret the un-inversion of the yield curve, and the absence (so far) of a downturn, as a sign that the original omen was a false alarm.

Were a new round of headwinds to threaten the American economy and re-invert the curve, the central bank might wrongly dismiss the signal and under-respond, thus bringing on the foretold recession.

It could also be that the slump that was predicted still looms ahead.

Less than a year has gone by since the yield curve first inverted.

Perhaps more important, each of the past three pre-recession inversions reversed themselves before the ensuing downturn began.

So while financial markets are celebrating a bullet dodged, the bullet may still be on its way.

Subzero Interest Rates Are Luring Insurers to Risk

Usually the most strait-laced of investors, insurance companies are letting loose to gain some income, drawing the attention of regulators.

By Jack Ewing

Credit...Yarek Waszul

MUNICH — It was a crisp fall morning, and Tom Wilson was contemplating the latest sign that the world of finance had turned upside down.

Greece had just sold bonds with a negative interest rate. It was the most recent example of how policies that revived growth after the last financial crisis have forced investors to effectively pay governments to assume custody of their money.

The amount of this kind of debt has soared in recent years, and now exceeds $17 trillion.

“Maybe I’m old school, but it just feels weird,” said Mr. Wilson, the chief risk officer of German insurer Allianz, in his office in Munich. “It feels bizarre to have negative interest rates.”

It’s more than bizarre. A growing number of economists, regulators and former central bankers are warning that European insurance companies — traditionally some of the most strait-laced of investors — are among the market players most at risk of a meltdown because of all the negative-interest-rate debt.

Insurers make money by investing the billions they collect in policymakers’ premiums. As they hunt for a return, any return, some companies are venturing into ever-riskier assets.

For the people who manage these billions, said Brian Coulton, chief economist of the debt ratings firm Fitch, “there has been a need to take on more risk.”

The so-called search for yield among investors has broad implications, creating demand and driving up prices for real estate, low-rated corporate debt and other risky assets; generating bubbles; and potentially setting the stage for the next financial crisis. Europe has more of this debt than any other region.

The impact on the insurance industry is drawing increasing concern. Last year, regulators conducted tests to see what would happen if rates spiked suddenly: Six of 42 large insurers would suffer losses large enough to drain their capital below legal thresholds, the tests found.

Insurers would probably be able to manage gradual increases in rates, said Dimitris Zafeiris, the top risk expert at Europe’s insurance regulator. But “if it happens quickly,” he added, “it raises questions about the impact on financial stability.”

Typically, insurers seek to earn a modest return while keeping the money safe in case it is needed to pay claims. European insurance companies were big buyers of bonds issued by countries like Germany or Switzerland that have impeccable credit histories.

But when the return on those super-safe bonds dwindled over the past decade, and then turned negative, insurers and other investors began buying riskier assets like corporate bonds rated BBB, or just above the level considered junk. A lot of money is at stake. Insurance companies in Europe collectively have assets of 11 trillion euros, or $12 trillion.

Recently regulators have become especially concerned that insurers have been loading up on a kind of investment known as collateralized debt obligations, or C.L.O.s for short. C.L.O.s are mortgages and other loans that have been packaged into securities. They bear ominous similarities to the securities that helped cause the 2008 financial crisis

Banks, pension funds and insurers may be underestimating the risk of C.L.O.s, the agencies that oversee those industries in Europe said in a joint report in August.

The Financial Stability Board, a group of central bankers and regulators from Europe, the United States, China and other countries, is also worried. The board said on Oct. 13 that it was scrutinizing whether C.L.O.s posed a risk to the global financial system.

The quandary for insurers is that fewer and fewer bonds — generally safe investments — pay a positive interest rate. A few weeks ago, even Greece sold short-term bonds with negative interest. In an auction, investors bid the rate down to negative 0.02 percent.

The bond sale was extraordinary considering that, less than a decade ago, investors in Greek government bonds were forced to take losses of 50 percent as part of a bailout plan.

Low and negative interest rates are no accident. They are the deliberate result of policies by the European Central Bank to deal with a debt crisis and chronic slow growth. The bank has purchased bonds on the open market to push down interest rates. And as a further inducement to lend, the E.C.B. charges a negative interest rate on deposits that commercial banks stash in the central bank’s coffers.

There is a growing backlash against these stimulus measures.

Low and negative interest rates have rippled through “the entire financial sector,” a group of former central bankers said in a letter to the European Central Bank in October. The scramble for higher rates has pushed up the price of riskier investments and “ultimately threatens to result in an abrupt market correction or even in a deep crisis.”

Whether to continue to encourage negative rates will probably be the key question confronting Christine Lagarde, who succeeded Mario Draghi as president of the European Central Bank bank on Nov. 1.

Mr. Draghi said last month that negative interest rates had “been a very positive experience,” stimulating growth and helping reduce unemployment. “The improvements in the economy have more than offset negative side effects from low rates,” he said.

At Allianz, Mr. Wilson’s job is to protect the company’s assets, which total €974 billion, or $1.1 trillion, of which €729 billion is invested in financial markets. That’s not counting €1.6 trillion that Allianz manages for other people through its fund management units, PIMCO and Allianz Global Investors.

Mr. Wilson said Allianz had avoided the C.L.O.s that so alarm regulators. But Allianz has about €150 billion of corporate debt rated just one notch above junk.

There has been an explosion in investor demand for these risky BBB bonds, because they offer better interest rates yet are still considered investment grade.

Regulators fear that a deep recession or other shock could force ratings agencies to downgrade BBB bonds en masse. That could cause a panic, because insurers or other institutional investors that are barred from holding debt less than investment grade would be forced to sell at fire-sale prices.

Mr. Wilson said Allianz’s holdings were diversified enough that it could cope with a rash of downgrades. He argued that insurance companies, despite their enormous presence in financial markets, were unlikely to be the cause of the next financial crisis. They are less interconnected than banks, he said, meaning that the problems of one insurance company would be unlikely to spread like a pandemic through the financial system.

And unlike banks, insurance companies are not dependent on a continuous supply of short-term credit, which can dry up suddenly if banks lose trust in one another. That is what happened in the 2008 financial crisis.

Others are not so sure insurance companies are benign, pointing out that a troubled insurer could create turmoil in bond markets that could easily spread to banks and create a broader crisis.

Some insurers “are as systemic as banks,” said Christoph Kaserer, a professor at the Technical University of Munich who has written about the industry.

The pressure on insurers to buy riskier assets is growing the longer interest rates stay low. Bonds that the companies bought years ago, when rates were higher, are continually maturing. The insurers must try to reinvest the proceeds in a way that earns a similar return.

“The longer the low interest rate environment prevails, the higher the impact of the reinvestment risk,” said Mr. Zafeiris, head of the risks and financial stability department at the European Insurance and Occupational Pensions Authority, Europe’s main insurance industry regulator.

Mr. Zafeiris said in an interview that, as a group, European insurers were healthy. But he added, “There are always outliers.” (Confidentiality rules do not allow him to name names.)

No big insurance company has failed because of negative interest rates, but the ratings agency Moody’s considers the outlook for the industry in Germany to be negative, in part because of negative interest rates.

Allianz has remained profitable, and the company’s share price is close to its 12-month high, an indication investors are not too worried.

The big question is what will happen if there is some kind of shock to the financial system that causes government and corporate debt to abruptly lose value. Mr. Wilson said he worried about that, too.

“I think the probability has gone up,” he said, citing risks such as trade war, conflicts in the Middle East or rising populism. “The number of triggers is manifold and increasing.”

Europe on a Geopolitical Fault Line

China has begun to build a parallel international order, centered on itself. If the European Union aids in its construction – even just by positioning itself on the fault line between China and the United States – it risks toppling key pillars of its own edifice and, eventually, collapsing altogether.

Ana Palacio

palacio101_Artur Debat Getty Images_earthspaceshadow

MADRID – Two months ago, in his address to the United Nations General Assembly, UN Secretary-General António Guterres expressed his fear that a “Great Fracture” could split the international order into two “separate and competing worlds,” one dominated by the United States and the other by China.

His fear is not only justified; the fissure he dreads has already formed, and it is getting wider.

After Deng Xiaoping launched his “reform and opening up” policy in 1978, the conventional wisdom in the West was that China’s integration into the global economy would naturally bring about domestic social and political change.

The end of the Cold War – an apparent victory for the US-led liberal international order – reinforced this belief, and the West largely pursued a policy of engagement with China.

After China became a member of the World Trade Organization in 2001, this process accelerated, with Western companies and investment pouring into the country, and cheap manufactured products flowing out of it.

As China’s role in global value chains grew, its problematic trade practices – from dumping excessively low-cost goods in Western markets to failing to protect intellectual-property rights – were increasingly distortionary.

Yet few so much as batted an eye.

No one, it seemed, wanted to jeopardize the profits brought by cheap Chinese manufacturing, or the promise of access to the massive Chinese market.

In any case, the thinking went, the problems would resolve themselves, because economic engagement and growth would soon produce a flourishing Chinese middle class that would propel domestic liberalization.

This was, it is now clear, magical thinking.

In fact, China has changed the international system much more than the system has changed China.

Today, the Communist Party of China is more powerful than ever, bolstered by a far-reaching artificial intelligence-driven surveillance apparatus and the enduring dominance of state-owned enterprises.

President Xi Jinping is set for a protracted – even lifelong – tenure.

And, as US President Donald Trump has learned during his ill-fated trade war, wringing concessions out of China is more difficult than ever.

Meanwhile, the rules-based international order limps along, without vitality or purpose.

Emerging and developing economies are frustrated by the lack of effort to bring institutional arrangements in line with new economic realities.

The advanced economies, for their part, are grappling with a backlash against globalization that has not only weakened their support for trade liberalization and international cooperation, but also shaken their democracies.

The US has gradually withdrawn from global leadership.

As a result, international relations have become largely transactional, with ad hoc deals replacing holistic cooperative solutions.

Institutions and agreements are becoming shallower and more informal.

Values, rules, and norms are increasingly regarded as quaint and impractical.

This has produced a golden opportunity for China to begin constructing a parallel system, centered on itself.

To that end, it has created institutions like the Asian Infrastructure Investment Bank and the New Development Bank, both of which mimic existing international structures.

And it has pursued the sprawling Belt and Road Initiative – an obvious attempt to position itself as a new Middle Kingdom.

Yet many, including in Europe, are not particularly concerned about the emergence of this parallel system.

So long as it brings ready access to project finance, it’s fine with them.

As Europe becomes increasingly alienated from the US, many Europeans also believe that they can improve their strategic position by situating themselves on the frontier between the two emerging worlds.

That strategy may offer some advantages, including opportunities for arbitrage.

But as anyone who lives on a fault line knows, there are also formidable risks: friction between the two sides is bound to shake the foundations of whatever is positioned atop the boundary.

This is especially true for the European Union, which is built on a commitment to cooperation, shared values, and the rule of law.

If the EU aids in building a parallel structure that contradicts its core values, particularly the centrality of individual rights, it risks severing its meta-political moorings – the beliefs to which its worldview is tethered.

A Europe adrift will eventually sink.

The solution is not for Europe simply to take America’s “side,” and turn its back on China. (That, too, would run counter to European values.)

Rather, the EU must heed Guterres’s call to “do everything possible to maintain a universal system” in which all actors, including China and the US, follow the same rules.

In this sense, the recent joint statement by Xi and French President Emmanuel Macron reaffirming their strong support for the Paris climate agreement is promising, as is Europe’s growing recognition that China is not only a partner or economic competitor, but also a “systemic rival.”

But this is only a start. Europe needs a robust China strategy that recognizes the profound, often subtle challenges that the country’s rise poses, mitigates the associated risks, and seizes relevant opportunities.

Achieving this will require perspective and discipline, neither of which comes naturally to the EU. But there is no other choice.

As soon as Europe stops defending the rule of law and democratic values, its identity – and its future – will begin to crumble.

Ana Palacio is former Minister of Foreign Affairs of Spain and former Senior Vice President and General Counsel of the World Bank Group. She is a visiting lecturer at Georgetown University.