The IMF last month published in its latest World Economic Outlook an assessment of the risks attending the global economy, long term as well as short-term. Among the long-term risks, the IMF cited the challenge of climate change and demographic factors. There is much talk at the moment of the implications for the carbon fuel sector of the actions governments might have to take to curb climate change. The International Energy Agency estimates that strict adherence to the target of limiting the rise in global temperature to 2°C above pre-industrial levels would leave $28trn of stranded assets in the carbon fuel sector over the next two decades. That is unsettling. For comparison, there were only $1.3trn of US subprime mortgages outstanding in March 2007. The value-impairment of those assets was then enough to wreak major damage on the world economy. Perhaps what we should take away from this is that global policymakers are very unlikely to countenance the degree of distress that destruction of assets on the forecast scale would entail. They are more likely to bet that the projections of the climatologists are wrong (not a hopeless wager), while making contingency plans for a hotter environment.
Standard assessments of long-term risks, such as the IMF publishes, typically do not cover all the threats to stability that might arise. We can be fairly sure that, among the ‘known unknowns’, the world’s population also has to face the prospect of pandemics and of seriously damaging strikes from extra-terrestrial objects, the former likely a more immediate threat than the latter. These are conventionally dismissed as fanciful scenarios because of their low probability within any given time-frame. While we know these events will one day happen, we do not know exactly when. Because they are rare, this seems to justify investors in leaving them out of their calculations of prospective returns from assets.
There is another long-term process, though, that investors really cannot afford to ignore. This is an ongoing change in geo-political conditions that is already patently under way. The New World Order of 1992, when Francis Fukuyama hailed the end of history on the view that a never-ending regime of liberal democracy and free-market capitalism under the hegemony of the USA had been inaugurated across the world, never quite came to pass. That vision is now fading fast under challenge from those nations, notably the BRICS, that reject US domination and aim to establish a pluralistic pattern of global governance in which the US-favoured solutions to problems would not necessarily determine outcomes. Signs are that US ruling circles are aware of the danger to their position and will attempt counter-measures to ensure that it is not weakened further. They have already withstood one challenge, from the Soviet Union during the Cold War. They may well feel they can see off this latest threat too.
A preponderance of military power is one of the pillars on which the USA has based its global hegemony. Figures on military outlays, published by the International Institute for Strategic Studies, show that in 2014 US military expenditure exceeded that of the next nine highest-spending nations. It was more than four times the spending of China, second on the list. We should note, though, that a dollar of military spending goes less far in the USA than almost anywhere else. Further, the USA aspires to a global deployment of forces, which nowadays no other country does, not even the UK. Meanwhile, there appears to be no diminution in the risks of conflict around the world. Most pointedly, after President Obama’s ‘pivot’ towards Asia, China appears to be stepping up its military activity in the region. The latest cause for alarm was China’s incursion into the Spratly Islands. Its coastguard vessels stood by while its engineers set up artificial structures, with a view, it seemed, to enforcing territorial claims in the area. Indications that China is building a new class of ‘coastguard vessels’ comparable in size to heavy cruisers have caused further alarm in the region. It seems to many that Beijing is intent on overturning the status quo in East Asia, which the USA has struggled to preserve over the past fifty years. Defence matters were at the top of the agenda when Mr Abe visited Washington this week for talks with Mr Obama.
China’s proposal to set up an Asian Infrastructure Investment Bank (AIIB) looked like an assault on the other pillar of US hegemony, namely, the might of dollar finance. Beijing was initially able to garner support for its plan owing to BRIC impatience at the USA’s failure to ratify reforms to the existing multi-national institutions, the IMF and the World Bank. The point about the AIIB is that it might grant credit with different conditions attached from those on which the World Bank and associated lending agencies have traditionally insisted. Since World Bank conditionality is a function of US economic thinking, it is not surprising the initial US criticism of the AIIB was that it would mark a break with sound principles that have governed official lending for years past. Seen from Washington’s viewpoint, it must have looked that way. The problem for the US Administration is that other governments, including those of some of its closest allies, no longer feel they can prioritise good relations with the USA at the expense of their relations with China. After all, China’s growth has contributed more than the USA’s to the increase in world GDP over the past five years. Further, one of the rules proposed for the AIIB’s operations is that only nations that are signatories of the AIIB treaty may supply goods bought with the aid of the new lending institution’s loans. Among the USA’s close allies, only Japan is still standing aside from the AIIB, consistent with the strong strategic bonds between the two nations in East Asia. The US Administration appears to have recognised, belatedly, that it has little hope of stifling the AIIB at birth. With this comes the hard lesson that no longer is the USA the only power that can take the initiative in moulding global affairs. China is likely to follow the establishment of the AIIB with setting up the so-called BRIC bank. This institution will pool some of the reserves of its member-states and operate, parallel to the IMF, in granting credit to temporarily hard-pressed nations. It could be an even more potent threat to the Washington-based international order than the AIIB.
More subtle, but perhaps ultimately more damaging to the USA’s dominance, is China’s determination to reform the IMF’s Special Drawing Rights (SDR). At present, the SDR’s value is set in line with a basket of currencies, which includes the US dollar, the euro, the Japanese yen and sterling. Beijing is pressing for the inclusion in this basket of the yuan, based on its economy’s global importance nowadays. In 2010, a Chinese proposal along these lines was resisted on the grounds that the yuan was not a convertible currency. Since then, the Beijing authorities have taken major steps to loosen capital controls; it would now be perverse to exclude the yuan from the SDR calculation by reason of its non-convertibility. However, the Chinese authorities have also spoken of allotting to gold a role in the monetary system, without being specific regarding detailed plans. Statistics published by the People’s Bank of China (PBOC) suggest its gold holdings have not risen in recent years but these data are widely believed to conceal the true position. Over the past five years, China’s domestic production plus imports of gold have substantially exceeded the China Gold Association’s estimate of the increase in private Chinese gold holdings. This raises the possibility that Beijing may be aiming to fix the yuan in a gold-exchange regime. Then, if the yuan were incorporated in the SDR, the latter unit, the value of which currently reflects wholly the gyrations in fiat currencies, would itself have a link, albeit tenuous, to gold. It might then, across the world, come to be preferred to the US dollar as a store of value. The US dollar’s dominant role as a reserve currency would then have been fatally undermined.
If that is the plan, it could be hard for the USA to resist it without adopting measures overtly hostile to China. But a great deal is at stake. Historians might observe that the shift in hegemony from one nation or region to another has been a regular feature in the progress of civilisation. The last shift of this kind occurred in the 1914-45 period when the hegemony passed from the British Empire to the USA. This was a relatively smooth transition, however, and to that extent atypical. The USA was not the only claimant to the dominant role. Germany also aspired to that position and, for a time in the 1920s, the Soviet Union seemed to have the tide of history running in its favour. If either of these powers had been able to establish their dominance, the subsequent course of world economic history would have been radically different from what it turned out to be. In the event, the UK virtually gifted its hegemony to the USA. This was one reason why the transition was smooth. Another, and perhaps more important, reason was that the ideological underpinnings of the British and US hegemonies were similar and to a large degree shared. They both rested on the precepts of free-market capitalism and individual rights and responsibilities (the UK only turned socialist after it had lost its hegemony).
The key question, then, concerns the degree to which China shares ideological underpinnings with the USA. To the extent that it does, it might not matter much in the long term what is the outcome of its challenge to US dominance. The global economy would continue along familiar lines and the principles now governing investment would still be applicable. If, however, China’s future ideology differs substantially from that of the USA, the transition could be the most momentous economic shift since Adam Smith’s laissez-faire displaced the statism of Colbert as the guiding principle of world development. That historical parallel is worth studying, since the process was not continuous nor did it proceed at the same pace everywhere. In the late nineteenth-century, for example, protection through trade tariffs made a come-back as a means of nurturing industry in the USA and in Germany. Even so, the trend was towards establishing the maximisation of profits as the motive force driving economic activity. This has culminated in the cult of shareholder value and in the financial engineering that benefits shareholders, at the possible future cost to bondholders that entails.
The eagerness with which China has, seemingly, embraced capitalism since the days of Chairman Mao may lead us to suppose it would not much matter, from an investment point of view, whether or not global hegemony passes from the USA to China. However, we need to be cautious about assuming that Chinese behaviour bearing some similarity to that in the West reflects the same ideological preconceptions. It is tempting to believe that actions that look similar spring from similar motivation. A topical example is the assumption that China is about to embark on Fed-style quantitative easing when any bond purchases the PBOC undertakes are more likely to be aimed at tidying up banks’ balance sheets. The overriding concern of China’s leaders is to perpetuate the regime that entrenches them in power. Economic objectives are merely a means to this end. Accordingly, the Beijing authorities would be unlikely to prioritise maximisation of shareholders’ returns, if this conflicted with their broader political imperatives. A world with China as hegemonic power would be materially different from the present state of affairs.
None of this is to say that China will come to displace the USA and dominate the world. Washington’s awareness of the danger suggests that it will mount a strong reaction against Chinese encroachments. But, for the long-term investment outlook, that is the point. It is becoming increasingly difficult for US leaders to pretend that their disposition of forces is not directed against China, as Mr Obama tried to do this week while entertaining Mr Abe. International tensions between the economic super-powers seem set to rise as it becomes harder to disguise their rivalry.