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Saturday, May 5, 2018

China, Trade and Trump

By Roy C. Smith

Perhaps it is now not unusual in the age of Trump to send an inexperienced team of officials with differing views on trade to Beijing for a two-day photo-op to deliver their “demands” for adjusting the “unfair” US-China trade balance. Among the seven US delegates, only Robert Lighthizer, the official US Trade Representative, has expertise in negotiating the endless minutia of trade issues. Though nominally led by Treasury Secretary Mnuchin, no one on the delegation seemed to be in charge or to speak for the president, something Commerce Secretary Wilbur Ross knows very well - last summer he negotiated a deal with China to reduce steel production that Mr. Trump later rejected as insufficient.

The Chinese side, quickly banged together by Liu He, president Xi Jinping’s new economic chief, replaces officials from the Commerce Ministry that were the previous trade experts. Liu’s team, trained in economics and finance, but inexperienced in trade details, seems to be fielded particularly to respond to the Trumpian form of blustery, highly politicized negotiations.

Neither side knows each other very well. Mr. Lighthizer said “we are going to spend the next year developing how we deal with each other.” If so, Mr. Lighthizer must assume his Chinese counterparts will not respond to the demands soon, or even take them seriously until they know each other better.

The US demands were an opening salvo of an economic artillery barrage that will go back and forth for a while. They include a unilateral reduction in China’s trade surplus with the US of $200 billion by 2021 (increased from $100 billion indicated before the meeting, which the Chinese said would be impossible), the ending of subsidies to Chinese tech companies competing in world markets, an immediate end to cyberespionage of commercial trade secrets and a strengthening of intellectual property protections, a lowering of Chinese tariffs on products in “non-critical” areas, opening of Chinese markets to foreign investments and services, and a promise to take no action, especially in the agricultural sector, in response to unilateral US tariff increases and other moves. These include the recent US announcement of higher tariffs on $150 billion of Chinese exports, restrictions on acquisitions in the US by certain Chinese companies and of exports to China of certain high-tech products, and penalties imposed last month on ZTE, a Chinese telecom company, for violating US sanctions on Iran.

China has already said it might open its markets to easier terms for foreign investment and is considering lowering some tariffs, but was unwilling to commit unilaterally to slashing the trade deficit. China recently announced a Made in China 2025 program as an essential upgrading of the economy with an emphasis on high technology industries. On May 5, a day after the Beijing talks ended, China announced the formation of a $47 billion China Integrated Circuit Industry Investment Fund to advance the 2025 plan. The US objects to this plan because of the large amount of government subsidies it will contain.

So, a year-long set of trade negotiations has begun with both sides firmly dug in. Nothing much is likely to happen for a while. China is not in a hurry and doesn’t face mid-term elections in the fall.  

But, China too has large political interests at stake in these negotiations. Newly anointed president-for-life Xi Jinping is in the process of consolidating all powers in China in the Chinese Communist Party (and himself).  His propaganda machine is constantly busy promoting Xi’s dynamic leadership, his “thought” and his “Chinese dream” even though growth is slowing, financial risks are increasing, and the problems of China’s huge aging population are becoming apparent. Like Mr. Trump, Mr. Xi has a populist side that appeals to nationalistic sentiments that the propaganda folks keep warm. He wants China to be recognized by the US and other countries as a great power, and not appear as Japan in the 1980s, so driven by economic ambitions that it could be forced into concessions by the US. Indeed, after the recent negotiations with the US team, Xinhua, China’s official news agency, pointed out that in a trade war, China was better off because of its strong centralized leadership, strong domestic consumer base, and “greater desire” (than the presumably soft Americans) to protect the current global trade system.

Mr. Trump’s style of deal-making is not unique in trade negotiations. Indeed, Richard Nixon, frustrated that Japan was not conceding to his trade policy demands, suddenly imposed a 10% surtax on all Japanese imports to the US. Japan responded by offering some concessions on quotas that solved the political problem Nixon had with US job losses for a while. But the trade imbalances continued and Ronald Regan followed a similar strategy a decade later.

China has emphasized that it is in a stronger bargaining position than Japan in the 1980s. Maybe it is, but the US is China’s largest trade partner, and its open markets continue to be important to China’s future. Meanwhile, China’s economic growth rate has declined from the 10% range to something around 6% despite enormous stimulus efforts and lose credit standards that threaten its financial stability. A trade war with the US certainly would not be convenient.

Economic forces already at work, however, will reduce the trade deficit on their own over time – rising costs for labor, land and raw materials have already caused some companies to move their manufacturing to a lower cost locale, and China will have a growing requirement to import goods as it becomes more of a market-driven consumer society. Meanwhile, while the deficits remain, US consumers enjoy lower prices and corporations pay lower interest rates as China recycles the surplus to invest in US securities, factories and acquisitions to protect its global market access. A great many Americans benefit a little from our present trade with China, but a few have lost their livelihoods. Cold-blooded economists don’t lose any sleep over the disparity, but hot-blooded politicians do.

China was admitted to the World Trade Organization in 2001 at president Bill Clinton’s strong urging. The US trade deficit with China was then less than $100 billion (it is now $375 billion, 2% of US GDP). China was granted some relief from WTO rules because it was a developing country. Some say because of China’s enormous growth since then, and the impact of its concentrated export activity on local businesses in the US and the EU, China should be regarded as a fully developed country and play by all the rules. China says with 60% of its population still poor and an urgent need to upgrade local manufactures to supply local markets, it should not be required yet to do so. And, China is still a one-party state with 150,000 state-owned enterprises that retains many aspects of the command economy it once was.

What's needed now is a set of practical compromises that both sides can live with and feel good about because they add real value.

These might start with a revised accounting system for calculating export values – The iPhone X costs about $370, according to one expert, for its various software and hardware components. Chinese content for assembling the units, however, is only 3% to 6%, or only $10 to $20 per unit. (The rest goes to companies in South Korea, Japan, Taiwan, the EU and the US, illustrating how Apple’s global supply chain works). On the other hand, Chinese content of commodity items like steel exports is nearly 100%.  If we ran the accounting to count only Chinese content, the pressure points would be different. China has excess and unprofitable capacity in steel and other commodity items that China needs to shut down in its own interest. If they are not shut down, the US can file dumping charges with the WTO and impose a special tariff on steel. Such tariffs have been imposed by almost all of Mr. Trump’s predecessors on a case-by-case basis. Mr. Trump could score some points by claiming his metal tariffs would be used for job retraining for displaced workers. But shutting down excess capacity, as Mr. Ross tried to do would be better. China knows it must do this sooner or later and would be better off doing so now.

Mr. Trump might propose that China agree to use its best efforts to offset the adjusted, net trade deficit with the US by increasing imports from the US, which could be of agricultural commodities, liquid natural gas (soon to be abundant in the US) and various forms of financial and other services. An accounting could be kept, and the process monitored to be sure that China conforms to the agreement, but how it does so would be left to it.

A special US-Chinese unit could also be established to continually monitor and address mutual security issues. The US wants to be sure that Chinese hacking of commercial trade secrets is ended and intellectual property protected. The Chinese want to be able to develop their technology industries, which the US should not object to if the effort conforms with restrictions on government subsidies recognized by the WTO and the EU. The US should leave private sector trade and investment in the high-tech sector to market forces, except for highly specific cases involving national security.

Having had the necessary dramatic opening session to satisfy local populations that each country is hanging tough on this important round of trade talks, it is time to get them off the stage and settled into quiet discussions of the complicated but hugely important trade relations between the two countries. A pragmatic solution awaits.

Saturday, March 31, 2018

RIP: Mother of the Modern EU Her Party Wants to Leave

by Roy C. Smith


Margaret Thatcher died five years ago this week. She would have hated the debacle of the Brexit vote and the shambles that have followed, because she did more than anyone to shape the modern European economy in which she wanted Britain to play a leading role.

When she became prime minister, the EU was the European Economic Community, a stodgy assemblage of 12 countries hoping for benefits of integration but badly in need of reform and rejuvenation. She was a true believer in free markets, deregulation and competition and on reforming and rejuvenating Britain after decades of weak economic performance and currency depreciation. Right away she repealed foreign exchange controls that had been in place since 1914, cut income taxes and battled unions. But she had a larger vision – to “privatize” hundreds of state-owned-enterprises (many of them nationalized by previous Labour governments) that then represented 10% of the UK GDP. Doing so would return billions of pounds to the Treasury, enable collection of taxes on profits, and return the companies themselves to being competitive in world markets. And, ordinary Britons could become capitalists by buying shares in great British companies. A long stream of British privatizations in coal, iron and steel, automobiles, gas, electricity, water supply, railways, trucking, airlines, airports and telecommunications began in 1981.

But for privatization to occur on a large scale, multi-billion £ stock issues would have to be sold. The financial infrastructure of the City of London, however, was antiquated and not up to handling such large issues. The City also needed to be reformed along free market lines, with the chips falling where they may. So “Big Bang,” announced in 1983 to be implemented in 1986, came into being and did the job. Simply by forcing the London Stock Exchange to negotiate commissions, allow “dual capacity” (of trading and sales, etc.), and open membership to all qualified comers, the system was transformed into Europe’s most competitive and efficient financial marketplace. Not long afterward, all of the countries in the EEC, fearing that the securities business in their countries would migrate to London, copied the Big Bang example and modernized their systems too. They followed her example, not some decree published in Brussels. Today, integrated European capital markets are the largest segment of the global capital market. In 2017, they generated over $4 trillion of new debt and equity issues, more than in the US market.

By the end of Thatcher’s term in office, more than 50 British companies worth more than £50 billion were privatized, restructured and made competitive. Soon it was clear to other EEC governments that privatizations worked, were popular with citizens, and generated returns of capital and tax revenues that eased governmental finances considerably. By the late 1980s, all of the other EEC countries were actively engaging in large privatization issues of their own. They in turn were followed by IPOs and other equity market transactions that transformed the closely-held private sector of Germany, France, Italy, Spain and other countries.

But Thatcher was not content to limit her reform ideas to Britain. In 1984 she appointed euro-skeptic Arthur Cockfield to be a member of a European commission studying economic reforms. Like Thatcher, Cockfield was a strong advocate of free markets; he arrived with a lot of data and a lot to say about integrating and liberating European trade and industry. He was the driving force behind the Single Market Act of 1986, the EECs most import reform effort. It incorporated the “Four Pillars” of the EU (freedom of movement across EU borders of goods, services, labor and capital) that was formed a few years later. After implementation of the Single Market, every company in Europe had to reconsider its business model and strategy. They were now part of a much larger, integrated marketplace and nationally protected local market dominance became a thing of the past. This strategic rethink, together with revitalized securities markets, lead to the first-ever European M&A boom that began around 1985 and has continued since, making it a vital part of a global M&A market that periodically does more transactions in Europe than are done in the US M&A market.

Finally, after forcing through financial reform, privatization and the Single Market act with its ensuing merger boom, Thatcher appeared in Bruges, Belgium in September 1988 for her snow-famous address to the College of Europe on Britain’s future role in the EEC. She began her remarks by saying that “if you believe some of the things said and written about my views on Europe, it must seem rather like inviting Genghis Khan to speak on the virtues of peaceful coexistence!”  But she explained, “Britain does not dream of some cozy, isolated existence on the fringes of the European Community. Our destiny is in Europe, as part of the Community.”

She also acknowledged that Britain under her leadership had fought back over regulation and other issues that she thought were unnecessarily constraining to the UK. Then she added her nest remembered line: “We have not successfully rolled back the frontiers of the state in Britain, only to see them re-imposed at a European level with a European super-state exercising a new dominance from Brussels.” But, this did not mean she wanted to leave Europe, only to use the UK’s powerful influence and example, as she had successfully been doing, to persuade Europe to maximize the utility of the private sector and minimize the notion of a super-state.

She was never a believer in go-it-alone, nor did she ever deviate from the basic idea that a great country like Britain had to be part of the global scrum to influence it. She would never have agreed to the Faustian bargain that David Cameron made with his backbenchers to offer a dangerous referendum on EU membership in exchange for their support as party leader, and she certainly would have hated the result.  

Britain’s post-Brexit future is certainly unclear. But what is not unclear is the enormous transition of financial markets, the vitality of the private sector and operational effectiveness of the EU’s integrated private sector that is now the world’s second largest GDP (at purchasing power parity), just behind China and ahead of the US, serving more than 500 million people. No one was more influential in bringing this to be than Mrs. Thatcher.

Monday, March 12, 2018

Lloyd’s Voyage

By Roy C. Smith

Frisay's news that Lloyd Blankfein would retire from Goldman Sachs at year end was a surprise to almost everyone. He will have served 12-years as Goldman’s CEO, longer than anyone else except Sidney Weinberg (who retired in 1966), and is one of the longest serving CEOs among today’s major banks. Blankfein replaced Hank Paulson as CEO in 2006, having transformed the firm’s Fixed Income, Currency and Commodities division into a trading powerhouse that was arguably Wall Street’s most dominant player.

Indeed, trading accounted for 68% of firm-wide revenues in 2006, and 73% of profits. Goldman Sachs’ return on equity was 33% and its price-to-book ratio was about 2.0. The stock was trading at $170 per share then, more than three times its IPO price in 1999. Blankfein, originally hired by the J. Aron division as a gold trader, took over the FICC division in 2002 and initiated a massive change in the orientation of the firm from traditional investment banking to a wide-ranging trading colossus that operated around the world and around the clock in hundreds of different instruments. 

Extraordinarily for the securities industry, this enormous growth and transition was accomplished without any major acquisitions, or dilution of ownership that such acquisition cause. The expansion was accomplished entirely in house, working with that wonderful Goldman Sachs DNA that is both feared and revered throughout Wall Street and the City.

Blankfein, however, had little time to enjoy his and the firm’s achievements. Soon after taking over from Paulson, he and other analysts noticed that rising housing prices, upon which a boom in mortgages and mortgage-backed securities was built, had ceased and indeed, reversed direction. Realizing that this could mean an end to the boom (or worse) he ordered a reduction in Goldman’s trading inventory, a reduction that was strongly opposed by some of his trading barons. He prevailed in the struggle that ensued, however, which some his counterparts (Citigroup, Merrill Lynch, Morgan Stanley) did not and steered Goldman Sachs through the financial crisis that followed with barely a scratch. Later, however, he had trouble explaining to Congress why the firm periodically adjusts its own exposures to its future outlook, without consulting its trading counterparties that through buying and selling positions are simultaneously adjusting their own positions. In the end, Goldman Sachs agreed to a $550 million settlement with the Justice Department for infractions of this sort.

After the financial crisis of 2007-2008, Goldman Sachs went through a number of regulatory changes that permanently altered its business. After the Lehman failure, the Federal Reserve required Goldman to became a bank holding company, which provided some advantages but many costs and disadvantages as well. Basel III and Dodd-Frank, and their myriad parts and pieces, came into effect imposing vastly increased regulatory compliance costs and greatly limiting the firm’s freedom of maneuver. There was no escaping this – Goldman had about $1 trillion of assets and was clearly a “systemically important financial institution,” so it had to change its business model to accommodate the new limitations.

Twelve years after Blankfein’s succession, Goldman’s total revenues are less than they were in 2006, and for 2017 trading represented only 37% of revenues, nearly half of what they were then. The stock price is about $100 per share higher, but the price-to-book ratio is only 1.46 (after a 20% increase in the stock price in the last six months), and return on equity was 10.8%.  Indeed, most of Blankfein’s tenure as CEO has been spent surviving the crisis and reengineering the firm for a duller, less expansive future. If he is feeling some regulatory fatigue, we can forgive him for looking for something else to do at 63.

It is curious that Blankfein’s retirement announcement should come so close to Gary Cohn’s, his former deputy who left last year to join the Trump team. There may be some wondering whether there will be a job switch, in which Blankfein would follow his Goldman CEO predecessors John Whitehead, Bob Rubin, Steve Friedman and Jon Corzine to Washington, and Cohn would come back to pick up where he left off but enriched and fortified by his White House experience. Don’t count on it – these things are rarely so simple – Blankfein has been more politically active as a Democrat than Cohn was, and in any case may be fearful of losing reputation by association with Mr. Trump’s team. And, though Cohn has had a full-career at the firm, as every Goldman Sachs CEO has before him, the water filled in behind him when he left and others are in waiting.

So maybe, now having been a king, Lloyd Bankfein, will be content to lay back and be a philosopher, author and philanthropist, as his predecessor, Hank Paulson, and friend Michael Bloomberg have done. Why not? He’s earned a good rest and some peace and quiet.

from Financial News,  Match 12, 2018

Wednesday, March 7, 2018

How Wrong is Trump on Protectionism?

How Wrong is Trump on Protectionism?

Roy C. Smith and Ingo Walter

It’s hard these days to find anyone concerned with the national interest who hasn’t been raised on the idea that tolerably efficient markets are better than rigged markets. Properly structured, they help ensure that resources are put to best use and the public has access to the best products and services at the best price. And when things like technology or consumer preferences shift, market discipline assures structural change in the economy to redeploy resources from activities of the past to those of tomorrow. Of course there are always winners and losers – for sure in the short term – and adjusting to new realities can be painful, But in the end the system is stronger and grows faster than under any other arrangement that’s ever been tried. Best of all, market-based opportunities and market discipline works with human nature, not against it.

That’s the way it is with international trade and the notion of comparative advantage. People, companies and countries should focus on what they do relatively better than others and acquire what they don’t, each on terms determined by the market. In so doing, their welfare will be higher and its growth will be faster than it would be otherwise. Deviate from this principle, and a price will have to be paid in the form of lower welfare and slower growth.  There’s no way around it.

So what happened with President Trump’s plan to impose high tariffs on steel and aluminum imports (with some negotiated exemptions) and then doubling-down on protectionism by hitting China on an array of “sensitive” products?

Maybe he and his advisers don’t believe basic economics. Maybe they believe international markets are already rigged, so a bit more won’t hurt. Maybe they think that we’ve done a really bad job getting people in distressed industries redeployed, so they deserve a break paid-for by healthier sectors and the general public. After all, politics is politics. And people who believe they are facing a bleak economic future – often an existential threat - form a powerful voting block. Meanwhile, those who will pay the tab for protection may hardly feel it and must rely on arguments based on the overarching principle of liberal markets. It can be an uneven political battle at times. And it’s never hard to point to other countries’ protectionist practices – in trade policy and liberal market access, nobody has clean hands.

But there are plenty of cheaper and more effective ways of addressing the kinds of “fairness” issues that give rise to today’s protectionism. Admittedly, the US has had a poor record of walking the talk and successfully and efficiently helping to redeploy resources, notably labor. Farmers say there are two ways to harvest corn. One is conventional way in the cornfields. The other is to go behind the barn and seek-out the few whole kernels left in the hog manure. The Trump plan seems to fit squarely in the second category, an economic blunderbuss that will hit importers, supply chains, exporters, foreign markets that take massive amounts of US exports, consumers - and maybe the US economy as a whole as some benefits of the Trump tax cuts are wasted on the inevitable costs of protectionism.

Besides the directly affected products in the Trump target-zone and those hit by retaliation, at stake here are the rules of the game that allow the benefits of market economics to work its magic on a global scale, where trade and specialization form one of the key drivers lifting welfare and growth among billions of people worldwide. Since 1937 the US has been the most important advocate of letting global markets do their work. The US has been instrumental in launching every round of global trade negotiations, and every President across the political spectrum from Roosevelt to Kennedy to Nixon and onwards has identified America’s national interest fundamentally with pursuing freer international trade in both goods and services. The core principles are “non-discrimination” in how market-access is opened to competitors, domestic versus foreign, one country versus another, together with “reciprocity” – we open our markets to foreign suppliers in return for their opening markets to ours. Both can be lumped into “fairness,” as in Trump’s “free and fair markets.”

The fact is that well-functioning markets need rules that anchor its basic principles, along with effective dispute settlement procedures. Again the US was the motive force behind both the 1947 General Agreement on Tariffs and Trade (GATT) and later the World Trade Organization (WTO). And when countries want to accelerate the efficiency and growth benefits of freer markets, something that may not be possible on a global basis, they may set up regional trade arrangements like the original European Economic Community (now EU) or the North American Free Trade Association (NAFTA) – not quite as beneficial as freer global markets, but better than the status quo. That option has likewise been under Trump policy assault in the case of both the Trans-Pacific Partnership (TPP) and NAFTA.

By apparently ignoring the factual power of globally freer markets, the Trump Administration betrays a critical US legacy based on a core belief in market outcomes that has overwhelming evidence to back it up. It also betrays America’s legacy of leadership in creating the global institutions to make it happen, cumbersome as they might seem at times. It puts the US on a slippery slope to some bad outcomes that will gradually become apparent and begin to poison the political chalice. In any case, the Trump tariff increases on steel and aluminum slam the EU and Canada and Mexico, among the leading US partners in seeking to assure sustainably accessible global markets. All three have their own protectionist practices that have not been successfully negotiated over the years, and all three have received Trump exemptions. Shooting yourself in the foot is not the best way to change the behavior of others.

But wait! Maybe Trump actually has a coherent plan, with a bulls-eye painted on China. Everything else may be a side-show – with the Europeans and others quietly cheering him from the bleachers.

Does China practice trade fairness market discipline? Hardly. China takes few prisoners in state support for exports and strategic investments abroad, stiff-arming foreign players in its domestic markets when it suits them, or in the murky calculus of state-owned businesses and banks. And there’s not much light between political targeting and competitive targeting in China. Non-discrimination and reciprocity often don’t seem to be in the Chinese vocabulary. It has violated key commitments under the WTO since it joined in 2001. But like Japan a few decades earlier, China has increasingly come under tough pressure from trading partners to play by the all-important rules of global trade and take its share of responsibility for a viable trading system. Toddlers are cute to have around the house, but not after they grow to 300 pounds.

Most importantly, China will eventually feel the effects of the kind of resource misallocation that results from persistently violating the spirit of those rules. Candidly, Chinese will often say “we will adjust, but on our schedule and terms, not yours.” China to Trump on protectionism in Twitter-speak:  “Won’t work. All wrong. Really bad.”

But Trump is also very good at borrowing ideas. His trade initiatives echo targeted measures taken by Richard Nixon, Ronald Reagan and George W. Bush over the years.  Each was intended to be shocking, but ended up with some voluntary or negotiated settlements, enough anyway to take the item off the political stage and allow a victory lap. By this logic, Trump aims to make a fuss over China tariffs, which can end in trade arrangements that will entail some backing-off and avoid a downward spiraling trade war that nobody wins. Trump could even include some sort of "surtax" on certain imports with sufficient proceeds (perhaps a few billion) to fund another try at a national worker retraining program – and sell it as a fair price to be paid by millions to fund assistance to the small number who are hurt. Could be a plan, if it can be made to work. But then, Trump is also very good at changing his mind.

Monday, February 26, 2018

The Real Signal from Anbang's Takeover

By Roy C. Smith

Last week the Chinese government seized control of Anbang Insurance Group, a hyperactive financial conglomerate with assets of about $300 billion, to avoid its collapse. Anbang’s free-wheeling, billionaire chief executive, Wu Xiaohui, who founded auto dealerships in 1996 that grew into car insurance, banking and overseas real estate, was detained by Chinese official last June and has been held in custody since for “economic crimes.”

Anbang, is one of China’s so-called “Gray Rhino” companies founded by China’s first wave of successful entrepreneurs. Others include fast-growing conglomerates such as Fosun International, HNA Group and Dalian Wanda Group that have feasted on cheap debt provided by state banks while spending lavishly to build their empires. (Gray Rhinos are so named after a 2016 book by Michele Wucker about facing obvious but ignored dangers). The companies relied on important connections with government officials for their access to business opportunities and finance, but they may now be an endangered species.

A dramatic failure of any high-flying company is big news. In China, however, big news also contains signals from the government for the people to absorb. What might the signals be in this case?

First, Mr. Wu, 51, in pursuit of Anbang’s interests, seems to have ignored some recent government policy guidance. Anbang was among the first Chinese companies to make major acquisitions abroad, including a $2 billion purchase of the Waldorf Astoria in New York in 2014. This was OK with the government when it happened, demonstrating that Chinese companies could be important players in the global investing world. But things changed after the Chinese stock market crash of 2015, and the government wanted to restrain such acquisitions to conserve foreign exchange and support the yuan. Wu wasn’t listening, however, and proceeded in 2016 to offer over $14 billion for the Starwood Hotel Group, and, in 2017 to discuss the purchase of 666 Fifth Ave., a troubled New York office building owned by Trump son-in-law, Jared Kushner’s family. Both deals were abruptly halted in mid discussion without explanation, presumably under Chinese government pressure.

Second, Anbang’s means of securing finance for its various acquisitions is not fully known but is thought to come from the sale of “wealth management” products, a lightly regulated, non-bank “shadow banking” activity that has grown substantially despite government efforts to more closely manage the country’s credit system. Wealth management products began as higher-risk bank loans that banks wanted to sell in order to comply with tightening government rules. Brokers would buy the loans and resell them at interest rates higher than banks offered to depositors. Thus, the loans were removed from the banking system, but became hard-to-manage liabilities in the Chinese financial system as a whole. Just as the government began to show concerns about the rapid rise in all of the different forms of asset management products (which rose to $15.4 trillion by 2017), Anbang appears to have started selling its own wealth products (i.e., loans) on a large scale.

Third, Mr. Wu is not an ordinary oligarch. He is married to the granddaughter of the legendary Chinese leader Deng Xiaoping and has served as a financial advisor to her wealthy mother, Deng’s daughter, who is one of China’s premier “princelings.”  Mr. Wu is said to be close to a number of other princelings (children of high ranking Chinese Communist Party officials), some of whom are thought to be owners and directors of Anbang. As a privately-owned company, Anbang does not disclose details of its ownership.

China’s leader, Xi Jinping, now deemed to be as powerful as Deng ever was, is also a princeling, though apparently not connected to the Anbang princeling set. Indeed, the Anbang case is a good opportunity to warn other princelings not to assume they can rely on their special positions and influence to do things that otherwise would be contrary to government guidance. Indeed, the Anbang case illustrates that princelings (even almighty Deng princelings) can be brought down just like anyone else if they fail to shown appropriate loyalty and obedience to the Xi regime.

Finally, there is the question of why the government took over Anbang the way it did, instead of quietly propping it up or letting it fail. China’s insurance regulator said government officials would run the company for one or two years, until it had been restructured.  Though there was some indication that Anbang’s financial position had soured, and this may have triggered a wave of wealth product redemptions, this does not appear to have been visible in the market before Mr. Wu’s arrest. Some sort of regulatory assistance, together with management changes might have been enough to save the company, but even without assistance it is not clear that Anbang’s failure would threaten China’s financial system, which has tradable financial assets of about $30 trillion.  Anbang may not have been too-big-to-fail, but it’s debt investors have been bailed out.

The answers are not clear, but (a) Chinese bankruptcy practices and laws, revised in 2007, are relatively untried and undeveloped and a $300 billion failure may be more that the government feels comfortable handling – and, not being able to do so might make China look bad, (b) Anbang debt and equity losses might have been considerable -- and would be concentrated uncomfortably on the middle class purchasers of the wealth products and smaller banks and other non-bank lenders that Anbang utilized, but most important, (c) such losses might trigger a general panic in China’s financial markets (many observers believe banks and shadow lenders are under-reserved for losses after a decade of easy monetary policy) and through contagion become a national liquidity crisis?

Thinking of such a possibility must remind officials of the 1989 financial collapse in Japan, the Asian Meltdown in 1998, and the US financial crisis of 2008. Any sort of similar crisis in China could be very destructive to its economy.

So, it is much easier for the government to simply take over Anbang, like the US took over Fannie Mae or AIG, to avoid a market reaction. Investors get paid, the system holds together, life goes on and all the important signals get sent.

However, the most important signal may be that China’s financial system is too weak, overextended and vulnerable to collapse to be left to the free market, so the government has to intervene frequently to hold it together. Thus, the government has committed itself even more so to being the country’s interventionist economic manager and Mr. Xi’s promise when he first took office to let free markets pay a “decisive role” in China’s economy is even more remote than ever. Denial of market forces requires authoritarian forces to replace them. If this continues to be so, China’s long-term future is surely much bleaker than many observers now think. Perhaps it too is becoming a Gray Rhino.

Saturday, February 24, 2018

One Cheer For New York's Subway

Ingo Walter

For a habitual subway user in Manhattan since 1970 - and a maybe a dozen other cities around the world from time to time - the drumbeat of subway criticism can get a bit much. Words like crumbling, obsolete, filthy, rat-infested and unreliable roll as easily off the tongues of hassled straphangers as the above-ground chattering classes in their limos and Ubers. Politicians join the chorus when it suits them, talking a good game during short political cycles while earning a solid F for securing their legacy by creating and maintaining vital investments with 75-100 year time-horizons.

And even when useful projects actually get done (there are only two in my lifetime, both unfinished), completion schedules can span generations and leave behind eye-watering cost overruns – capital deadweight that produces exactly nothing of value yet saddles taxpayers with massive debt service for years to come. In short supply today is the kind of far-sightedness that helped create New York’s bridges and tunnels, its parkways, its world-class water system, and of course the original subway infrastructure. And there’s today’s serviceable PATH, finished in 1908 under William G. McAdoo, later Secretary of the Treasury under Woodrow Wilson. (“Let the public be pleased.”)

But wait! Are things really so bad that we need to rebuild from scratch? In some ways they’re even more challenging. It’s a good bet that reimagining a world-class subway system that can secure the City’s future will be the biggest brownfield transport project ever undertaken. It requires reconfiguring and reengineering century-old layouts intertwined with all kinds of critical gas, heat, electric power and communications utilities that have accumulated like barnacles on a ship’s hull over the decades.  Don’t believe it? Look down an open manhole sometime.

Along with rebuilding most of the system’s stations and yards, any serious rehab has to happen while close to 6 million testy passengers have to be moved around the City every day. In all kinds of ways, greenfield subway projects (or greenfield superimposed on brownfield) have it much easier in places like Singapore, Paris, Shanghai - and even London - extending or developing brand new high-speed and local lines on time and on budget, even in the most ancient of cities. Passenger are not unreasonable by nature, but morale does reflect the likelihood of seeing real benefits before they pass from this earth.

Maybe the constant criticism is also overblown in the broad scheme of things. It’s hard to complain about the small part of the subway layout I normally use in Manhattan - especially with a good memory of the way things used to be.

Gone are the graffiti-covered windows blocking the view of station stops, the piles of onboard trash, and even some of today’s clunkers have started new and improved lives after an amazingly attractive renovation, just like an old Boeing 777 after a D-check.

Gone are the aggressive and often physical panhandlers and the omnipresent platform stench that would drive people and companies to seek civilization elsewhere. Even the new generation of (sometimes talented) subway gymnasts has been toned-down. Many conductors, agents and transit police now make an effort, and it shows. Passengers with plenty to gripe about are mostly civil and offer seats to those who obviously require them. And there’s no need to worry anymore about misunderstood eye-contact with fellow passengers, thanks to today’s electronic substitutes for Prozac.  

Except for the glaring omission of efficient subway links to the airports - virtually unique among today’s important business and financial centers - visitors from overseas can get used to our system with a bit of practice. It’s New York, after all, and there will be some good stories to tell when they get home.

So there’s always a bright side, and today’s subway ecosystem has one too. There are plenty of people who deserve credit for things not being even worse, much worse. Sustainability is a different issue. Pendulums swing, and there’s no guarantee that we won’t revert to the bad old days rather than a bright new dawn.  The City has to play the cards it’s been dealt. In New York there’s not that much “greenfield” around to accommodate big new projects that move the needle, and “brownfield” is disruptive and expensive.

On top of that, nobody wants to pay - something that the subway shares with big infra-structure projects around the world. Well thought-through and executed, these projects are enormously productive year after year over decades and sometimes centuries – to the point where even huge development costs fade into insignificance. But the costs fall on people in the here and now, while the benefits are widely dispersed over space and time. So the former don’t want to pay and the latter can’t easily be made to pay. Think a New York subway renaissance will run a deficit in cost-benefit terms? Pure nonsense. So we end up with enormously socioeconomically profitable projects that cannot be financed.

There are plenty of solutions. Tax those who don’t pay but benefit most directly, like landowners and developers enriched by the subway - taxes that may in part get passed along to residents and businesses in higher rents and ownership costs. Those who benefit most directly are made to pay, but nonetheless are better off. Or go for a broader tax net that covers all of New York’s residents and visitors with a permanent City subway tax and hotel surcharge.

Don’t use the subway? Too bad. Your limo battles less traffic the more people do. Commute from the burbs and walk to work? Too bad. The value of the subway is baked into your home value and your ability to resell it. Want to make it progressive? Add features like a nonresident vacancy tax on all those unused luxury condos owned as a bolt-hole by foreigners and finance bigger discounts for the poor and the elderly. There’s plenty of revenue elasticity in a “city of the future” like New York.

New York’s subway is a hidden treasure . All it takes is visionary political leadership, disciplined execution and management, and imaginative financing to unlock it for the future prosperity and vibrancy if the City.