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Sunday, July 9, 2017

Ramping-up Financial Sanctions on North Korea

by

Ingo Walter

With North Korea intent on developing operational nuclear-capable ICBMs able to strike the continental United States in the foreseeable future, things are coming to a head. There’s been plenty of debate on US military and diplomatic options, yet none are attractive or apparently workable. But one course of action can still be leveraged, does not require broad intergovernmental consensus and is hard to evade: Financial sanctions applied to North Korea and to any global financial organization seeking to assist it by transferring funds on its behalf or on behalf of another financial entity collaborating with Pyongyang. This tactic is workable, if not entirely fail-safe, and can cause the kinds of difficulties for North Korea that they have for Iran and Russia. China’s recent sharp reaction to pretty mild sanctions imposed on only one of its banks for aiding and abetting North Korea’s financial dealings is encouraging.

The sanctions enforcement route now runs through US dollar clearing of international payments. Financial transactions that enable sanctions-avoidance almost always touch the US dollar clearing system, and when they do, they attract US law enforcement. Indeed, US prosecution of major international banks for helping evade sanctions in order to preserve their business with targeted countries has changed the game. Without the intentional cooperation of these banks, economic sanctions cannot be avoided. By raising the cost of violating the rules to significant levels, US bank regulators and the Department of Justice have helped sanctions throttle the financial air supply.

Foreign banks and their home governments may or may not agree with the policies underlying the US sanctions. But the fact is that global banks today continue to settle most of their trade and financial transactions in US dollars. This is an important business for these banks, and they must have access to the US clearing and settlement apparatus to conduct it. Like it or not in the dollar world, US law is the law. Banks must comply or face consequences, pressure that has been escalating steadily since 2005.

Altogether, banks such as HSBC, ABN Amro, Standard Chartered, Lloyds, Barclays, Credit Suisse have each coughed up plenty in fines and penalties. BNP Paribas’ 2014 admission of a criminal violation of US payments sanctions involving Iran, Cuba and Sudan led to an $8.9 billion fine, forced resignation of key executives, and imposed a one-year suspension from dollar clearing. Shares in sanctions-busting banks lost value as a result of the settlements and increased transaction risk exposure - BNP Paribas stock lost about 4% of its value soon after it was reported to be in settlement discussions.

Perhaps more important than the size of the fines, penalties and stock market impact, however, is that enforcement action BNP Paribas was brought under criminal, not civil law. Only regulatory forbearance negotiated in advance avoided the Bank’s suspension from various US businesses. But they were warning shots. The specter of Arthur Anderson demise after a ‘guilty’ plea back in the days of the Enron scandal Enron days is ever-present.

Sanctions that restrict access to the dollar market can be very burdensome for targeted countries like North Korea, particularly those with mineral resources that need to be sold abroad, or that need to import strategic raw materials and components as part of a military buildup. Sanctions long applied to Iran are thought to have been significant in motivating the 2015 nuclear agreement. Sanctions on Russia in the wake of the Crimea annexation and destabilization of Ukraine seem to have had broadly negative effects on the Russian economy in the years that followed, although they did not involve restricted access to the US dollar payments infrastructure.

Still, Vladimir Putin recently said he hopes to switch Russia’s enormous dollar trade in oil to Chinese renminbi in order to reduce the impact of possible financial sanctions. That may be naïve, since the renminbi is neither convertible nor widely used as a currency for international trade. Russia may assume it can find banks willing to help subvert sanctions via the renminbi, but participating banks would run the risk of putting their US dollar business in jeopardy. On the other hand, as North Korea’s key enabler, the evolution of an internationally viable financial market in China could eventually help undermine trade and financial sanctions directed at the toxic regime.

Now and for the foreseeable future, the US can impose financial sanctions unilaterally in the dollar market without the kind of broad agreement required for other international policy issues. And it has the ability and the willingness to detect and meaningfully punish those who violate its laws, including denial of access to its financial market. Dealing with a North Korean threat that could become existential for the United States requires a fully equipped economic, financial, political and military toolbox. With many of those tools thought to be ineffective or too risky, ramping-up financial sanctions presents one realistic option to apply serious pressure on the rogue government.

Friday, July 7, 2017

Will a Financial Crisis undo China’s Superpower Ambitions?


By Roy C. Smith

The media has been focused lately on the rising influence of China and the confrontational bi-polar superpower world that lies ahead.[1] But before we acknowledge China as a superpower, it needs to demonstrate that it can maintain the long-term economic power that enables its geopolitical rise: a challenge that past superpower aspirants failed to manage successfully.

China has to deal with a slowing growth rate that may be worse than it seems and carries the risk that a disgruntled citizenry will begin to question the legitimacy of the Communist Party to rule the country without either Communism or any sort of popular consent. For years, both Chinese and other observers have noted that, defacto, consent to rule was exchanged for economic growth and prosperity provided by the Party. No one was ever sure of what the minimum growth rate to retain consent was, but many suggested 7%-8%. This year, China is forecasting growth in the 6.5% – 7% range – high everywhere else, but low for China.

But even this target may be tough to meet without fudging. China’s export customers are growing at less than 2% and shifting economic resources to the consumer sector has continued to lag. Much of the growth that is occurring is from the agricultural sector and overproduction of basic materials and manufactures, which global trade scrutiny is making harder to dump in overseas markets. Some of the growth, too, is from costly roads and bridges being undertaken well in advance of demand for them, and from large-scale demonstration projects (e.g., the Asian Infrastructure Investment Bank, and the One Belt One Road project). Meanwhile, Chinese profit margins are weak and wealthy Chinese investors have been shipping capital out of the country. The Chinese stock market has been lackluster since the Shanghai index soared to 5,100 and then plunged back to 3,000 in 2015.

Importantly, in its efforts to support a sagging growth rate, China may have pulled back too far from the necessary economic and financial reforms needed to transform the country into a mature market-driven economic system, and increased the chances of a financial crisis that could halt or seriously slow growth rates, exacerbating the legitimacy-to-rule issue.

Under the Xi Jinping government, some reforms have been undertaken, but these have been offset or undermined by blunt-force efforts to increase growth through easy credit and government spending. Indeed, there seems to be significant competition between the financial regulators fearing systemic risks and those more politically minded officials who fear unemployment and labor unrest more. Balancing the two concerns, in an economy the size of China’s with many decentralized vested interests, and limited policy tools is a very difficult task.

Last year the Bank for International Settlements said China was three years away from a financial crisis.  How likely is this to happen?

Based on historical precedent for rapid growth Asian economies (Japan, Korea, Taiwan, Thailand, Indonesia), a debt-based financial crisis seems inevitable. China’s total debt has soared in recent years to $28 trillion, 277% of GDP, with non-government debt ($17 trillion) representing 170% of GDP, twice what it was in 2011. Moody’s recently downgraded China’s sovereign debt to A1.

Most of the increased lending has been to weak state owned or other government supported entities experiencing growth constraints, which has raised concerns about bad debts. Chinese bank loans have increased by 15-30% annually since 2008%, though Chinese estimates of non-performing loans increased only to 1.75% of outstanding loans, though this is the highest ratio in eleven years. Few foreign observers take this non-performing number seriously; indeed, in September 2016 Fitch estimated the ratio to be ten times larger, representing as much as $2 trillion.

Bank regulators have made some significant efforts to contain credit risk. Whether these will be sufficient in a crisis in which market values could be decimated, threatening systemic failure is hard to know. But, the efforts to reduce bank exposures are in conflict with central and regional governments’ and the central bank’s efforts to support credit for growth that began in 2014.  This has inspired borrowings by “local government financing vehicles” and several other makeshift off-the-books ways to get around the regulator’s controls that have sprung up in recent years. S&P has recently downgraded several LGFVs, which, together with other “shadow banking” entities, now represent $9 trillion of assets. Two-thirds of these are considered bank loans in disguise, as they were arranged and presumably are backed by banks.

The four largest Chinese banks (assets of $12 trillion, 40% of total bank assets) are captive to government demands. China has a high savings rate and the government has $3 trillion of foreign exchange assets that might be used to shore things up in the event of a crisis. Indeed, the government tapped into these reserves in 2006 to clean up the balance sheets of the big banks that were going public then. The banks are assumed to be backed by unspoken government guarantees, with risks containable within a closed-loop government credit mechanism that is insulated from foreigners and private capital markets.

But this closed-loop assumption that many foreign observers have used to shrug off fears of credit collapse in China, may be different from what it was. The many new initiatives to spread credit beyond the banking system, and a bond market now with $10 trillion of capitalization, have transferred substantial market risk to private institutions and investors, including international investors. This exposure is now huge and vulnerable to price and liquidity changes that could sink many institutions unless aided by the government. If this should happen, and today it seems likely despite China’s increasing global eminence, it could invoke consequences similar to those of other recent financial crises.

Japan learned in 1989, that its relatively closed-loop financial system was highly vulnerable to a credit crisis following the bursting of a stock market and real estate bubble. The financial crisis that ensued was crippling to the Japanese economy and ended the superpower ambitions Japan then had once and for all.

Similar crises affected the high-growth Asian economies in 1997-1998 as credit losses threatened banks that had to be assisted by their governments and the IMF. The rapid growth rates of these countries have been sharply curtailed ever since

And of course, we in the West also learned in 2007 and 2008 that a relatively modest market segment (subprime mortgages worth $600 billion, in a $5.5 trillion mortgage backed securities market in a combined US bond market of $30 trillion) could be subject to severe pricing shocks as some investors, fearing credit losses, ran for the exits and created a global liquidity crisis that contaminated most other asset classes, including corporate bonds, commercial paper, bank CDs, real estate and equity markets, and, a bit later, sovereign debt. This extraordinary crisis, unexpected and largely unprecedented, was significantly enhanced by global market linkages that required substantial governmental intervention to resolve, and has sapped growth rates for nearly a decade.

China has considerable power and resources to deal with a crisis, including its lack of need for parliamentary approval to do whatever it wants. But it lacks experience in managing an increasingly market-oriented financial system, and in making the internal political trade-offs to serve both growth and regulatory control simultaneously. Indeed Japan, and the US and the EU had resources also, and used them to fight their crises. But crises, particularly in countries accustomed to the government closely managing the economies, can destroy confidence necessary for the economies to maintain investment, consumption, and – most important, especially in China --confidence in the future of growth, employment and well-being for all the citizenry, not just the urban well-to-do constituting 12% of the population.

A financial crisis could end China’s hopes for superpower status, but if the crisis is deflected or skillfully managed, it could fortify superpower claims for a long time.





[1] See Graham Allison, Destined for War, Gideon Rachman’s Easternization, and Amitai Erzioni’s Avoiding War with China, among others.

Thursday, June 29, 2017

Brexit and Lingua France: Does Foreign Language Training Make Economic Sense?


by

Ingo Walter

Not known for his sparkling sense of humor, EU Commission president Jean-Claude Juncker may be seriously underrated in the “zinger” department. In a well-reported speech (in French) a couple of weeks ago, he prefaced his remarks by noting (in English) that after Brexit the English language would gradually lose its commercial importance to the 24 continental European languages, notably French and German - the two post-Brexit EU “working languages.” His remarks, widely reported in the media and overanalyzed by the global elite, raised some interesting questions.

Imagine how much brainpower is invested by the thousands of Eurocrats, members of the European Parliament, national delegates, lobbyists and other hangers-on who are fluent or at least competent in four languages - the three current working languages plus the language of their home countries. The English, French and Germans get one exemption   each as do the Irish and Maltese, for whom English is the official language.  Plus many countries retain local dialects that have been remarkably persistent over the centuries, part of the enduring charm of Europe.

Becoming fluent in a modern foreign language takes a lot of time and effort, and comes at the expense of other activities that might be more productive. In the implicit cost calculus of the EU bureaucracy, it probably ranks with moving the annual plenary sessions of the European Parliament to Strasbourg from its HQ in Brussels due to political concerns early in the EU’s history. But things being what they are, within the halls of the EU and its agencies, the extraordinary commitment to modern foreign languages is likely to continue well after Brexit. Except maybe at the European Central Bank, which works in English despite the absence of the UK among its members.

Modern foreign languages have both personal and commercial value. Learning them involves investment in consumption or production, or both. Consumption-driven language investment allows access to literature in the original language, the performing arts, ability to converse across cultures, enhancement of tourism and a generally better informed and more cultured existence. Production-driven language investment allows better market access, lower information and transaction costs that ease commerce – international trade in goods and services, foreign investment and all kinds of financial flows. It can pay off very directly for a tour guide, for example, or in much more subtle ways that result in higher incomes that come from functioning more effectively in a multi-lingual world.

Languages are economic catalysts. They create lots of benefits without themselves being consumed in the process. And the more a language gets used, the more it gets used, with a tendency toward a winner-takes-all lingua franca. Unfortunately for Jean-Claude Juncker, it isn’t French or German. The drift toward English began in the far distant past, with the British exploration, trading and colonial history depositing the language the world over. Others like Spain and Portugal provided alternatives, but none had the domestic commercial, legal and business infrastructure to form a serious global challenge - or a powerful US acolyte. Even a credible newcomer like China stands little chance.

Today English is far enough down the slope of lingua francaness that arguing against it is like challenging gravity. Outside of commerce, English has come to dominate much of academia and technology as well, where ideas are heavily globalized. Other languages have liberally contributed key words or phrases for which English has no easy replacements - like entrepreneur and Schadenfreude, fait accompli and Wanderlust - and the English language is happy to incorporate them.  It is also relatively easy to learn, constantly evolving (as annual additions to the Merryam-Webster English Dictionary show) and eager to export plenty of its own words and expressions to other languages free of charge.

Even in the EU. It seems that 66% of EU citizens are competent in a foreign language, according to Eurostat – the EU’s statistical office - with 94% of them studying English, 34% studying French and 23% studying German at the secondary school level. At the primary school level 79% are studying English versus 4% French.[1]

In a recent study one of my students, Jessica Yang, conducted an interesting empirical analysis of the relationship between commercial and financial integration and cross-border migration in the EU and investments in learning foreign languages among pairs of member countries.[2] The study was based on a data panel containing both language-education stats and economic flows among four countries - Spain, France, Germany and Italy – so that paired conclusions could be drawn.

The causality, of course, could run both ways. Language education could lead to higher intensity of economic relationships among the EU countries examined. Or stronger economic ties among these countries could increase the personal payoffs from investment in language education and encourage attainment of fluency.

The finding? Rien du tout, Garnichts, niente. nada. Nothing? For better or worse, is seems that English swamps everything else. Casual observation over a couple of decades savoring the delights of Paris or Madrid – on and off the beaten tourist track - confirms this English language-creep, and practical business-related motives doubtless have a lot to do with it. But go ahead and study modern foreign languages anyway. You will be better for it. But for most people it won’t pay the rent.

In the rarified EU halls in Brussels, of course, form doesn’t necessarily follow function and there seem to be plenty of resources to waste, including brainpower dedicated to mastering multiple languages. Even so, English will doubtless continue to gain market share in remaining 27 member states well after the EU’s official languages drop from three to two after Brexit. Britain will leave behind a gift that keeps on giving. Stay tuned for Jean-Claude Juncker’s next bon mot on the subject.




[1] As reported in The Economist, May 13, 2017, p.47.

[2] Jessica Yang, “Foreign Direct Investment, Trade and Cross-border Migration as Drivers of Foreign Language Education,” Stern School of Business, New York University, 2015.

Saturday, June 24, 2017

The Apprentice: Borrowing a Little Common Sense From the Old World

by Heinz Riehl and Ingo Walter

“The Germans are bad, really bad,” President Trump tweeted a few weeks ago. How’s that? He really meant “They’re good, really good. So good at competing in world markets, that they’re really bad.”

So how come President Trump this week gave a speech on the need to take the modern “apprenticeship” pages from the German playbook and make the case for opening a new chapter on the US professional labor force - one that can compete more effectively with the best-trained and most productive workers around the world? Adapting the apprenticeship model to US conditions, currently pretty much limited to German companies manufacturing here, has a lot of potential but requires some new thinking.

America’s economic challenges today include labor shortages in key high-skill vocations – set against a large overhang of young people lacking marketable qualifications. True, the US is not producing enough technicians, programmers and engineers who understand “the hard stuff.” But we fall particularly short at the lower end of the skills spectrum, including plenty of college grads looking for meaningful work or functionally underemployed. Nor are these same college grads particularly good candidates for the many high-paying positions for skilled manufacturing workers, technicians and specialists.

Many are weighted-down by uneven high school preparation, lack of focus, and illusions about the world of work. So what else is new? Sounds like many of us at age eighteen. The obvious question is, should everyone go to college? The standard American answer has been “yes,” even though we are perhaps doing a disservice to young people who end up after 4-6 years of college, perhaps as better human beings but no better trained for productive employment than the latest crop of high school grads.

This reality contrasts sharply not only with the usual suspects like China and India, whose young people have voracious appetites for applied education and training, but also countries in “Old Europe,” like Germany, which has performed superbly in global markets and absorbing the unemployed despite high prevailing wages. Germany bounced back faster and better from the Great Recession than most countries, and one reason may be a more effective approach to vocation-oriented education and training. Germany eschews traditional university education for all in favor of challenging, highly structured apprenticeships — distinctly different from US-style on-the-job training.

German-type apprenticeship programs are tough to get into and complete. They combine practical training with classroom education equivalent to two years of college. Tracing their roots back to the medieval Guilds, apprenticeships continue to provide a path to professional success path for young people, even in a high-tech world.

Classic apprenticeships — more recently renamed “dual education”— are available for hundreds of professions, ranging from crafts like auto mechanics, bakers, chimney sweeps, masons, electricians, and opticians to tax accountants, insurance agents, restauranteurs and hoteliers. Apprentice-based careers include telecommunications, business analytics-based agriculture, marketing, public relations, and medical care.

Following secondary education, around age 16, professional education and training occurs predominantly via the "dual" system — "dual" because the know-how and skills for each profession are conveyed in two distinct settings: (1) A company, business, or workplace for the practical component; and (2) A related professional trade school for the more academic education content. Dual education takes between two and three years, with the apprentice working three or four days every week for the employer and attending professional trade school for one or two days. Besides the cost of training, the employer pays a modest wage.

The professional trade schools complement the practical learning with a profession-specific yet comprehensive, college-style education. Bakers learn the chemical composition of yeast and flour, bankers learn the difference between a mortgage and a loan secured by real estate, and all apprentices learn how federal, state, and local governments are organized and how elections work. Employers and schools cooperate closely. Importantly, apprentices are exposed in their employer’s business to mature, skilled, and professional adults as successful role models.

The typical apprenticeship concludes with a government-supervised examination confirming the successful apprentice as a certified professional in his or her occupation. Certification almost always leads to successful placement in a permanent position. The system also provides additional full-time schooling in a "master class," which again ends with a state-supervised examination. So the more ambitious can go on to become “master craftspeople,” supervising others and educating subsequent generations of apprentices. Only businesses employing one or more “masters” may hire apprentices, so there is always someone from whom young people can learn.

Germany’s arrangement is a successful model that can be adapted to provide job opportunities and well-paid careers for US high school grads — a time-tested system we could emulate to generate more skilled workers who can compete with the best craftspeople in global markets and create goods and services that people want to buy. The model is technologically robust and adaptable to disruptive technologies. And it is a ready-made approach to promote entrepreneurship among small and medium-size businesses — where the bulk of new jobs are created — and to rebuild the American middle class. Next time you call an electrician, see if the guy isn’t dreaming about going into business for himself and starting an electrical contracting business.

President Trump is onto something. As usual, the devil is in the details. But the idea has legs. We should learn from the apprenticeship masters of the Old World. With the right incentives, there are plenty of benefits to be had.