Latin America's insertion into the global economy. Source: Google Images

A decoupling of emerging markets from the struggling developed world is a myth, as we saw in 2011 when euro and US shocks caused a sell-off in EM currencies, including in Latin America. Next year could be rough as global growth slows. Countries from Brazil to China are rushing to reverse their earlier policy tightening. Softening Chinese demand should result in flat to softer commodity prices, affecting most countries in Latin America. The big wild card for growth will be the euro zone again. On this, it is challenging to be optimistic. Latin Americans borrow substantially from European banks, and so access to capital may be muted.

So, which countries in Latin America are best able to weather what’s coming in 2012? Countries with strong external balance sheets, macro policy flexibility, sizable domestic markets, and stable politics. Brazil generally passes this test, but its ongoing slide into stagflation — inflation above target and growth below 3% — suggests some limit to policy flexibility. Watch out for the Venezuelan election because no one knows what a post-Chavez world will look like. Mexico’s seems well-positioned for 2012, given a competitive exchange rate and rising exports, some dynamism north of the border, policy flexibility, and what looks to be a fairly quiet electoral season on the horizon. Yet Mexico is vulnerable to just the sort of developed market crisis that beckons toward year-end 2012: namely, a sell-off in the US dollar that could result from America’s inability to solve its government debt problem.

Can they stabilize the national debt? It's about growth, stupid!

The debt dynamics equation was in the past of interest only to sovereign credit analysts (such as this blogger) and macro policy wonks.  Now, more people want to know about it.  You can generate such an equation that is elaborate or not, but the gist is the following:  The primary budget surplus, that is, government revenues minus expenditures — not including interest expenses and earnings, must be large enough to cover the excess of the interest cost on the national debt over GDP growth, or else the debt to GDP ratio will rise. 

Primary surplus/GDP > Debt/GDP x (r – g)

…where r is the interest rate on the government debt and g is the rate of growth in GDP; r and g are either both expressed in real (inflation-adjusted) or nominal terms.

Many countries today have primary budget deficits, which means, unless GDP growth is stupendous, that is, in excess of the interest rate, then their debt to GDP is going to rise.

The debt to GDP ratio is a comparative measure of a country’s debt burden.  Think of it this way — you have the amount of debt your government owes, and you divide it by GDP, which is a measure of the size of the economy.  GDP, you may recall, is defined as the sum of the transactions (buying and selling) taking place in an economy in a given year.  Debt is divided by GDP in order to measure the capacity of a country to handle its debt burden, because, after all, you could tax all those transactions in order to pay off the debt. 

What the debt to GDP ratio does not tell you is how high taxes are.  For example, in Sweden tax revenues (broadly defined) represent a whopping 52% of GDP; whereas in the US and Japan, they represent only 32% fo GDP.  If you believe that high taxes squelch growth — and you don’t have to be in the Tea Party to do so — then you would be more optimistic about growth prospects in the US and Japan than in Scandinavia.

Now, it just so happens that Sweden’s GDP growth rate has not been consistently lower than that of the US or Japan in recent years; but you might think that over time, if US and Japanese politicians would stop ruining investor confidence with their antics, then these countries could grow more rapidly than Sweden.  Furthermore, both the US and Japan, again if their politicians would behave better (and here you can blame the Tea Party), have greater scope to raise taxes to improve debt dynamics than does Sweden.  It has been estimated that Japan, if it had a VAT tax as high as Europe’s, would balance its budget overnight.

So, growth matters, taxes matter, the interest rate matters, and the budget deficit matters. So, how do some of the sovereigns we see flash across our computer screens fare on the debt dynamics equation?  

Even though Italy has a high debt to GDP ratio of 120%, analysts and euro-officials trumpet the country’s primary budget surplus as an argument for why the government is solvent.  Well, that surplus has been squeezed down to near zero; and, given rising interest rates resulting from the euro zone crisis, an abysmal GDP growth record and poor growth prospects, the primary surplus would need to be between 1.5% and over 4% of GDP in order to stabilize government debt.  Hence, the market’s concern about Italy.

Spain has a much lower debt to GDP ratio than Italy, at just over 60%; however, its primary balance is in deficit of about 4% of GDP.  Yet Spain only needs its primary balance to be in balance, not surplus, to stabilize its debt to GDP ratio.  But closing that 4% gap is still quite a feat.  The new right of center government, with its majority in the legislature, may just be able to do this.  But the market still has its doubts.

How about France, which the rating agencies still have at AAA but have placed on a negative outlook? Its primary balance is in deficit like Spain’s, but only to the tune of 2.5% of GDP.  Yet its debt burden is higher, at 85% of GDP.  France too needs a primary balance that is in balance, but has less distance to go than Spain.  Still worries about France’s growth prospects — especially its international competitiveness — plague the markets. 

And then there is Germany, which has a sizable government debt burden of close to 80% of GDP, worse than Spain’s. Those pesky German states (lander) love to borrow.  Germany too requires a primary balance to stabilize government debt, but AAA Germany’s primary balance is currently nearly in balance, and its GDP growth track record has been impressive of late.  We’ll see if that continues.

The problem here is growth, stupid!  With high tax burdens, an ideological vice grip on the ECB, poor political leadership at the European and national levels, a lack of structural reforms, and a currency in grave doubt, prospects for GDP growth in the euro zone that would support virtuous debt dynamics are dim.

The UK, which thumbed its nose at greater European oversight of its budget, has a primary deficit of 3.5%, debt to GDP like France’s, and requires balance in order to stabilize government debt.  Yet the UK has the flexibility of its exchange rate and monetary policy to support GDP growth, which euro zone countries lack; however, the UK sends 40% of its exports to the euro zone, so its “splendid isolation” is a mere pipe dream.

Leaving the shores of Europe, we find the US and Japan with woeful primary deficits of 6% and 8% of GDP respectively, suggesting explosive deterioration in sovereign debt dynamics.  US debt to GDP is approaching 95% this year, and Japan’s, get ready for this, is crossing 225% of GDP!  However, given very, very low interest rates in both countries — how long they can get away with this is another story, but most believe they have at least a few years — and possibly better growth prospects than in Europe, both the US and Japan can stabilize government debt with a primary deficit of 1% or so of GDP. 

Japan of course needs much more than debt stabilization; it needs sharp debt reduction.  The other side of the coin for Japan and the US (and to a lesser extent the UK, where tax revenues represent around 40% of GDP, lower than most European countries) is that, should the Tea Party in the US and the factions in the Japanese diet allow some tax increase, then these countries could dramatically improve their debt dynamics.  Europe, on the other hand, can’t really afford to raise taxes, even though some countries are going ahead and doing it anyway.

If you are one of the few to hold a high place in the Chinese Communist Party life has to be good. You are running one of the world’s greatest powers and you don’t have to worry about elections next Fall, or the next Fall, or the…However, there is one major hangup to being part of the leadership of a Communist country: living a publicly austere and modest life. And not just you, but also your family and heirs. This last part is bubbling up some problems according to Jeremy Page recent piece on China’s ‘Princelings’:

One evening early this year, a red Ferrari pulled up at the U.S.
ambassador’s residence in Beijing, and the son of one of China’s top
leaders stepped out, dressed in a tuxedo. Bo Guagua, 23, was expected.
He had a dinner appointment with a daughter of the then-ambassador,
Jon Huntsman.

The car, though, was a surprise. The driver’s father, Bo Xilai, was in
the midst of a controversial campaign to revive the spirit of Mao
Zedong through mass renditions of old revolutionary anthems, known as
“red singing.” He had ordered students and officials to work stints on
farms to reconnect with the countryside. His son, meanwhile, was
driving a car worth hundreds of thousands of dollars and as red as the
Chinese flag, in a country where the average household income last
year was about $3,300.

The episode, related by several people familiar with it, is
symptomatic of a challenge facing the Chinese Communist Party as it
tries to maintain its legitimacy in an increasingly diverse,
well-informed and demanding society. The offspring of party leaders,
often called “princelings,” are becoming more conspicuous, through
both their expanding business interests and their evident appetite for
luxury, at a time when public anger is rising over reports of official
corruption and abuse of power.

These are high stakes for CCP. The CCP has largely traded their governing legitimacy from creating an egalitarian, communal society to one of promoting growth, growth, growth, but this does not mean that they have completely abandon the former. Having silver spoon fed young adults running around flaunting their connections and the financial and societal benefits it has brought them can create a backlash. The fact that the incoming CCP leadership will have only tangential ties to Mao’s revolutionaries of the recent past puts even more spotlight on these new leaders. Page details how the current CCP leaders are aware of the dangers these Princelings’ behavior may bring:

State-controlled media portray China’s leaders as living by the
austere Communist values they publicly espouse. But as scions of the
political aristocracy carve out lucrative roles in business and
embrace the trappings of wealth, their increasingly high profile is
raising uncomfortable questions for a party that justifies its
monopoly on power by pointing to its origins as a movement of workers
and peasants.

Definitely a story worth following…

Iran is back in the news again: bungled attempt to kill Saudi Arabia’s ambassador to the US on American territory, IAEA’s upcoming report which is expected to detail how the Islamic Republic is working toward a nuclear weapon’s program, President Ahmadinejad’s growing feud with the Supreme Leader, and of course Iran‘s support for the Bashir regime’s crackdown on it revolting citizens in Iran. David Sanger of the New York Times produced a nice synopsis of the Obama administration’s current strategy toward Iran, detailing American efforts to impede its progress toward going nuclear:

Iran may be the most challenging test of the Obama administration’s focus on new, cheap technologies that could avoid expensive boots on the ground; drones are the most obvious, cyberweapons the least discussed. It does not quite add up to a new Obama Doctrine, but the methods are defining a new era of nearly constant confrontation and containment. Drones are part of a tactic to keep America’s adversaries off balance and preoccupied with defending themselves. And in the past two and a half years, they have been used more aggressively than ever. There are now five or six secret American drone bases around the world. Some recently discovered new computer worms suggest that a new, improved Stuxnet 2.0 may be in the works for Iran.

Basically, anything that doesn’t involve an actual American (or Israeli) military strike or real sanctions on Iran‘s oil industry. Sanger also quickly layouts what a parallel containment strategy for Iran might look like:

The early elements of it are obvious: the antimissile batteries that the United States has spent billions of dollars installing on the territory of Arab allies, and a new Pentagon plan to put more ships and antimissile batteries into the Persian Gulf, in cooperation with six Arab states led by Saudi Arabia.

It seems to have reached conventional wisdom that the Obama administration has ruled out any serious military action to halt an Iranian nuclear reality, but analyst David Rothkopf thinks that may be naive:

But in the end, as dangerous as an attack might be militarily and politically, if the President believes there is no other alternative to stopping Iran from gaining the ability to produce highly enriched uranium and thus manufacture nuclear weapons, he will seriously consider military action and it is hardly a certainty he won’t take it. From a domestic political perspective, right now Obama’s strong suit is his national security performance. For the first time in years, he has taken the issue away from the Republicans. Right now they simply cannot attack him as being weak or assert they understand defense better. That is why they are so silent on the issue. Obama has only four real areas of vulnerability on this front. First, if he pushes too hard for defense budget cuts before the election, the Republicans will go after him. He won’t. He will seek cuts but will be comparatively cautious. Next, if there were a terrorist attack of some sort and the administration seemed unprepared or responded weakly, that would create a problem. But that is a perennial wild card. Third, if he distances himself from Israel, the Republicans will seek to capitalize on the sense some supporters of that country have that Obama is not a committed friend. There is already plenty of activity in that area … and the Israelis are eager to take advantage of their perceived election year leverage. And finally, if Iran were to detonate a nuclear bomb, Obama would be blamed and fiercely attacked for a policy of engagement that ultimately proved to be toothless.

Walter Russell Mead has also made this argument, though more persuasively. I wouldn’t be so quick to think that Obama would make such a move. Yes, he has shown a willingness to use violent force to kill terrorist enemies and participated in the aerial bombing of Qadafhi’s regime in Libya, but an attack on Iran would be a whole other animal. I believe Obama is still a firm believer in international institutions and law and would loathe the idea of going it alone (albeit with Israel) as there is little chance a major attack would be approved in the Security Council. Attacking Iran would also open up a plethora of unknowns (oil prices, counter attacks, etc.) that I don’t think the President wants to bring to the 2012 election. It would also undermine the benefits Obama will receive from his base by getting all US troops out of Iraq. However, Rothkopf and Mead should be applauded for going against the conventional wisdom.

In any case, after becoming a nearly forgotten topic amongst all of our economic dull drums, the Iran question is back in the news and obviously worth watching.

“China’s model is telling us you can be successful without following the Western example,” said deputy prime minister Arthur Mutambara, a member of an opposition party locked in awkward coalition with Mr. Mugabe, who has deep ties with Beijing.

The U.S. is the largest foreign donor to Zimbabwe, according to the Organization for Economic Cooperation and Development, which doesn’t count China as a member. The U.S. funnels much of its assistance through nongovernmental organizations, some of which are critical of Zimbabwe’s government. That hasn’t gone down well with many officials. “China is my favorite country,” said Mr. Mutambara a 45-year-old politician who attended U.S. universities.

Now, the US and the West shouldn’t jump up in alarm just from a few quotes from one government co-leader, but the statistics of economic influence should make them pay attention if they haven’t already:

China is now the continent’s largest trading partner, edging out the U.S. Last year, its trade with Africa reached $114 billion, up from $10 billion in 2000 and $1 billion in 1980, according to China’s State Council, or cabinet.

On a continental scale, China’s deal-making pace far exceeds the U.S.’s, according to Mthuli Ncube, Chief Economist at the African Development Bank Group. He estimates Chinese firms accounted for 40% of the corporate contracts signed last year, to 2% for U.S. firms.

Where are the American firms? What is keeping them from finding partners across Africa? Are these findings just a blip on Africa’s historical train or is the United States missing a boat that is not coming back? I don’t want to overstate this trend, but when one looks at these findings in the light of the current fiscal situation of the United States and Europe, well, it can make one believe that we are seeing a fading power being replaced by a rising one.

When eminent scholar Walter Russell Mead tackles a subject he does not do it on the cheap. One of his latest long articles attempts to discern the current trajectory of Turkey’s foreign policy and he takes his readers through quite a ride. Mead, an American history, smoothly goes through modern Turkish history and then ties the nation’s past into its current international outlook and posture:

Atatürk defeated the Greeks and the west to establish modern Turkey’s boundaries, and he was determined that Turkish “backwardness” would never leave his country exposed to this kind of danger again. That meant turning Turkey’s back on the “primitive” east, Islamic law, Arabic script and everything that lured the new secular Republic away from the stern task of modernization. The Turkish armed forces, immensely prestigious after their victory over the powers behind Sèvres, saw themselves as the custodians of Atatürk’s legacy — a role that they only finally seem to have abandoned this summer when the chiefs of the Turkish military resigned, allowing Erdogan to replace them with nominees of his choice.

Now that Prime Minister Erdogan, (pronounced AIR doe wan) has defeated Turkey’s secularists, he is looking to rebuild Turkey’s role as the leader of the Islamic world. In the Middle East he will have some success. The prestige of Turkey’s modernization and the admiration for its democratic transition from French-style secularism to something more, well, American gives him lots of prestige — especially in the ex-Ottoman world. This is a change….

In any case, Erdogan’s AK Party is interested in overturning Atatürk’s secularism and overcoming his rejection of Turkey’s Ottoman heritage. For many AK supporters, the Ottoman era wasn’t an era of darkness and backwardness that Turkey needs to forget. It was in some respects at least a golden age of prosperity and peace, when a Turkish Sultan was the Caliph of Islam and Islam was the most widespread and, perhaps, respected religion in the world. Europeans trembled at the thought of the Great Turk, and from Hungary and Algeria through Egypt and Iraq, his word was law.

For many Turks, a new arc of history now looks clear. The Turks under Atatürk and the Kemalists modernized; now they are returning to their Islamic roots with a unique blend of advanced technology and economic success. This is not about conquest or the restoration of an actual empire — the Turks are subtler than were the Greeks. Where the Ottomans ruled by fire and the sword, the modern Turks will lead Islam by example and inspiration; Turks have achieved while Arabs can only dream. Now Turkey, in this view, returns to lead the Arabs into the light and Turkey’s unique role and prestige among the Arabs will give it new power and stature in the west. One can see why many young Turks are optimistic about the most glorious prospects Turks have seen since Mehmed II (Mehmed the Conqueror) entered Constantinople in 1453.

Mead argues that Erdogan and his fellow AK leaders are making a calculated gamble by focusing on the East, attempting to be the leader of the Muslim world once again. As Mead poignantly describes, this strategy will present Erodogan’s government with numerous sticky issues:

These days, the world west of Turkey has mostly been ethnically cleansed and homogenized. The German minorities in central and eastern Europe were expelled back to Germany after 1945; except in the Caucasus the Soviets also cleaned ethnic house, moving Poles hundreds of miles west and shifting Turkish and other minorities to the east from places like the Crimea. The Balkan Wars of the 1990s and the struggle over Kosovo between Serbs and Albanians were one (one hopes) among the last European flare ups of the long wars of the nations which gradually forged modern nation states out of the ethnic and religious hodgepodge of Europe 150 years ago. Tens of millions died and tens of millions more were driven from their homes, but except for some occasional belches and booms, the volcano has finished exploding.

That is not true to Turkey’s east. Syria, Lebanon, Iran, Armenia, Georgia, Azerbaijan and Iraq (to say nothing of Israel and the Palestinian territories) are still on the ethnic and sectarian boil. None of these countries have borders that match up with their ethnic composition; religious divisions still have the power to kill; tribal loyalties are oblivious to artificial boundary lines. There is probably a lot of killing still to be done and a lot of ethnic and religious refugees to be made before these countries settle down into something like a final form.

Involvement with the east might start with expanding Turkish trade and enhancing Turkey’s diplomatic and Islamic profiles; it will be very difficult to ensure that it does not entangle Turkey into intractable conflicts across the region. Indeed, Turkish foreign policy has already been destabilized by the Armenian-Azerbaijani and Israel-Palestinian rivalries, and the Kurdish question in Iraq, Syria and Iran brings Turkey new and vexing headaches every day.

Is Mead on target with his claim that Turkey has turned their main attention to their south and east? I’m not quite so sure. The government is still outwardly in favor of joining the EU and though has had some recent (nothing really new) disagreements with NATO’s direction, they are no talks of leaving the Euro-Atlantic defense pact. Nevertheless, Erdogan and the AK are definitely devoting more of time than their predecessors toward their neighbors to the south and east and this looks to be a concerted and planned effort.

The Union of South American Nations

Will the Union of South American Nations (Unasur) and its monetary fund, Banco del Sur, be successful?

It has been difficult for emerging markets to diversify their sources of balance of payments (BOP) support. During the 1997-98 Asian crisis, the shame such Asian nations as Korea, Thailand, and Indonesia felt (their leaders and peoples, that is), when they had to go hat in hand to the IMF and accept harsh reforms for BOP support, led to calls for an Asian Monetary Fund to supplant the IMF as the lender of last resort. This fund took over ten years to establish; still, these days many Asian nations have ample fx reserves to weather a global slowdown on their own.

Such is the case with many South American nations. Brazil (with over US$ 350 billion in reserves) and Peru (with nearly $50 billion) are exemplary. Due to Chinese demand and the boom in commodity prices, most South American countries are in pretty good shape in terms of fx reserves. But, such countries with heterodox (read: unsound) economic policies as Argentina, Ecuador, Bolivia and Venezuela could see themselves under fiscal and perhaps BOP pressure. These governments follow policies at odds with IMF standards and would be prime candidates for Banco del Sur funds. Yet South American governments are a long way from agreeing on what policy conditions Banco del Sur would condition disbursements. Most countries would probably adhere to an approach not too dissimilar from the IMF’s. Finally, given the infancy of Unasur’s institutions, bilateral central bank swap facilities would be the preferable option to help countries in need.

The following post is an edited version of an article that appeared in the Jerusalem Post earlier this month by Pinchas Landau, author of The Landau Report, a newsletter and consultancy service addressing the needs of foreign firms and financial institutions active in Israel and the Middle East.

“Domestic fury, and fierce civil strife
Shall cumber all the parts of Italy…”

Julius Caesar Act III, Scene 1

As it happens, Italy was not the scene of domestic fury, let alone of fierce civil strife. Instead, the Italian government and parliament – at the urgent prodding of its lecherous leader Berlusconi – rushed through more and tougher austerity measures, in an effort to persuade the financial markets that Italy is not a basket case and to convince the European Central Bank to continue buying Italian government bonds. The ECB, seemingly encouraged by this display of political determination by the Italians – although over the firm objections of the German members of its governing council, did step up to the plate and buy both Italian and Spanish bonds, thereby preventing a total rout in the markets.

However, even with this support from the ECB, the Italian and Spanish stock markets lurched from one low to another over the week. This came as the markets were swept daily and almost hourly by rumors of liquidity problems at leading Italian banks and, far worse, major French banks as well. So while the Italian domino trembled – but did not (yet) fall – the next domino down the line, namely France, began to shake. Here, too, the response was seemingly firm: not only did the ratings agencies confirm that they had no problem with FrAAAnce’s triple A rating – despite having knocked the USA down a notch – but President Sarkozy summoned his senior ministers and instructed them to prepare further austerity measures for discussion and approval later this month. Here, too, the aim is to demonstrate that the political determination exists to do whatever it takes to stabilise the economy.

Formidable. But there is a problem with tough economic policies. They are great when you see the Powerpoint slides and Excel spreadsheets that show how expenses will be reduced and the deficit trimmed, so that key debt ratios improve over time. But if these fierce austerity measures are legislated and implemented as planned, they cause serious hardship to many people and engender major social dislocation. Economists will explain, rightly, that the alternative is worse – eventual breakdown of government and total collapse – but that sensible line still doesn’t play well among the people who actually bear the brunt of the budget cuts, the public sector firings, the elimination of welfare programs, etc.

Just how problematic it is to impose severe and prolonged austerity on a large country became abundantly, painfully, shockingly, clear in the UK this week. The Conservative- LibDem coalition that came to power last year had a mandate to cut government spending and raise taxes, so as to prevent Britain reaching the parlous financial state that Italy, France et al are now facing. The Cameron government has gone ahead with massive cuts in public spending. These measures have been fiercely opposed, as might have been expected. There have been major demonstrations by students and others, and some of these have turned very violent and very nasty. But that was to be expected – in Athens the austerity measures were worse and the intensity of the opposition was greater.

Yet the protests and demonstrations seen hitherto in the UK were in no way similar to, nor did they in any way prepare people for, the events of the last week. These were not demonstrations, or protests against anything specific. Instead, there has been a wave of wanton vandalism, perpetrated for the most part by kids.

Fortunately, this wave of violence has not cost lives, except for one incident in Birmingham. Unfortunately for its perpetrators and would-be imitators, it did something even worse, in the British scale of values. It attacked property. If, in earlier times, it could be said that “an Englishman’s home is his castle”, in the current secular age in which real-estate is the national religion, his home is also his church and sanctuary – and shopping centers are the social cathedrals. By attacking and burning shops and homes, the stupid, greedy kids have declared war on the middle class – and will pay dearly for their mistake.

They are smart enough to know that playing the role of disadvantaged victim – “you shouldn’t ignore us”, as some of the thugs explained – is the politically correct path to a rap on the knuckles, rather than a prison sentence. But they are not smart enough to realize that they have just helped consign that liberal mindset to the garbage can of history. Britain is now facing up to the consequences of five decades of social engineering and family collapse – in the developed country with the highest rate of teenage pregnancies, how many of the vandals have two parents, let alone functioning ones? – perpetrated by left-liberal ideologies, and three decades of economic Darwinism perpetrated by right-wing ideologies. These consequences are not abstract concepts, they are the “feral rats” (as a middle-class lady in Croydon termed them) that emerged into full view this week.

But as the rest of Europe is forced to rapidly dismantle its welfare state in an attempt to avoid bankruptcy, it will expose itself to the same consequences. Each country has its own brand of poisonous racial/ ethnic/ religious/ national/ class hatreds bubbling beneath the surface. As the crisis deepens these will spill over into domestic fury, fierce civil strife and the rest of Mark Anthony’s terrible prophecy.

Illustration by Edel Rodriguez (Source: www.thedailybeast.com)

With America’s latest market crash, the debt debate seems so ‘last week’ (hey, it was last week!), there is still much to learn from the tumultuous process. Niall Ferguson attempts to provide an outside perspective on the whole debt limit battle. It’s a pretty important outside perspective too; China:

Viewed from Beijing, it looked very different. Indeed, it’s hard to imagine what more we could have done to vindicate the Chinese Communist Party’s position that Western democracy is a form of institutionalized chaos to be avoided by all sane Asians….

The antics of American legislators take on a new significance when you realize how our leading creditor interprets them. As Beijing sees it, the last three months have furnished ample evidence that—regardless of what the American rating agencies may say—the United States is no longer creditworthy. Even if Congress has pulled back from the brink of outright default, many in China view the debt deal as at best a temporary fix. As the Xinhua News Agency put it, the 11th-hour deal has “failed to defuse Washington’s debt bomb for good, only delaying an immediate detonation by making the fuse an inch longer.” Meanwhile, the unspoken intention of the Federal Reserve is to debase the dollar through “quantitative easing,” which translates into Mandarin as “printing money.”

We all know that China is not just a spectator in America’s budget battles, but a key constituency. Ferguson details China’s skin in our game:

According to official figures, mainland China holds $1.1 trillion in U.S.-government debt instruments. But it’s an open secret that the Chinese authorities also like to buy Treasuries via intermediaries in London, Hong Kong, and elsewhere. Add the U.K. and Hong Kong figures and the total is closer to $1.6 trillion—about 17 percent of the federal debt in public hands. And if you include nongovernmental securities held in China’s international reserves, the U.S. debt to China rises to more than $2 trillion.

In that math one can see a rising power. In this math, provided by Robert Samuelson, can be seen a troubled, possibly falling power:

Europe represents about one-fifth of the world economy and buys about a quarter of American exports. While Europe’s debt crisis was confined to a few small countries, they could be rescued; other European countries supplied loans to substitute for the credit denied by private lending markets. In 2010, Greek, Irish and Portuguese government debt totaled about 640 billion euros (about $910 billion), less than 7 percent of the 9.8 trillion euros of debt of all members of the European Union.

 With Spain, Italy and possibly France now under financial assault, the situation changes dramatically. There are more debtor nations and more debt at risk. In 2010, Italy’s debt was 1.8 trillion euros; Spain’s 639 billion euros; and France’s 1.6 trillion euros. But there are fewer countries that can support a rescue; and some of them have heavy debts. Even Germany’s ratio of debt-to-gross domestic product (GDP), a measure of debt in relation to its economy, was a hefty 83 percent last year, similar to France’s. (The big difference between France and Germany is that Germany’s economy is growing faster.)

The United States and most of Europe’s finances are hemorrhaging and both are showing rather pathetic attempts to get their houses in order. Unless their trajectories change quickly, they, particularly Europe, may be forced to answer a final question, posed by Samuelson, in the affirmative:

Would China contemplate bailing out Europe? If it did, there would be a stunning transfer of geopolitical power and prestige to China.

It’s not exactly yellow cake, but the Wall Street Journal reported yesterday that the US Treasury Department accused Iran of aiding and partnering with Al Qaeda:

The U.S. for the first time formally accused Iran of forging an agreement with al Qaeda, helping operatives move money, arms and fighters through Iranian territory to the terrorist group’s bases in Pakistan and Afghanistan.

The U.S. Treasury Department outlined on Thursday what it said was an extensive fund-raising operation devised by al Qaeda that utilizes Iran-based operatives and draws from donors in oil-rich Persian Gulf countries such as Kuwait and Qatar.

The story needs more flesh, but this is still pretty alarming. The American public has been told for years that Iran did not have a partnership with Al Qaeda and in fact likely viewed the transnational terrorist group as an enemy (Shia – Sunni battle), but this evidence shows otherwise. It would be one thing if Al Qaeda just had operatives in Iran, but the Treasury Department said:

.. it had sanctioned six al Qaeda members for allegedly overseeing this network. The network’s head, Syrian-national Ezedin Abdul Aziz Khalil, is based in Iran and has been operating there under an agreement with Iranian authorities since 2005, according to senior U.S. officials.

The key part is ‘under an agreement with Iranian authorities’. Like I said before, there is much more that needs to be fleshed out of this connection before we can fully accuse top Iranian leaders of aiding and abetting America’s number one enemy, but if ever the Obama administration needed a  ‘smoking gun’ to rally public opinion and pressure the Islamic Republic, this is it.

this is a country that measures its annual supply of large-scale protests in the tens of thousands. For 2006, China’s Academy of Social Sciences reported the eruption of about 60,000 “mass group incidents,” an official euphemism for demonstrations of public anger involving at least 50 people. In 2007, the number jumped to 80,000. Though such figures are no longer published, a leak put the number for 2008 at 127,000. Today, it is almost certainly higher.

There is certainly no credible evidence that China is on the brink of an unforeseen crisis, but all that public anger points to enormous challenges on the road ahead. Emerging powers like India, Brazil and Turkey can continue to grow for the next 10 years with the same basic formula that sparked growth over the past 10. China, on the other hand, must undertake enormously complex and ambitious reforms to continue its drive to become a modern power, and the country’s leadership knows it.

The financial crisis made clear that China’s dependence for growth on the purchasing power of consumers in America, Europe and Japan creates a dangerous vulnerability.

A few weeks ago, I highlighted Henry Kissinger’s excerpt of his new book ‘On China’, which I was surprised to learn was about China. Have you stopped laughing? Good, I’ll continue. Well, I found an excellent review of Kissinger’s latest book by Zachary Keck from E-International Relations. Keck does a reader friendly, old fashioned book review where he smoothly intertwines Kissinger’s prior books and IR philosophies as well as other major works on the topic with ‘On China’. Keck was as impressed as I was with Kissinger’s emphasis and ‘ability to portray [the] mindset’ of various Chinese leaders:

Although China’s offensive deterrence is borne out of geopolitical realities, Kissinger does not overlook the importance of individual leaders. Indeed, one of the most noteworthy parts of the book is Kissinger’s intense focus on the nature of individual leaders and his ability to illustrate the dilemmas they faced. Given his nearly unprecedented access to a vast range of high-ranking officials on both sides of the relationship, Kissinger is uniquely qualified to tell this history. In doing so, Kissinger allows the reader to “look over the shoulder” of the statesmen in the best traditions of Classical Realism.

Overall, Kissinger portrays leaders in both countries in a fairly positive manner. This is especially true with American Presidents and occasionally their advisers (most notably, Zbigniew Brzezinski and Winston Lord), whom Kissinger finds little to criticize.

Although similar in many respects to his portrayals of American leaders, ultimately Kissinger’s accounts of their Chinese counterparts are more interesting. Kissinger clearly understands the difficult conundrums Chinese leaders often face when weighing the importance of good relations with the United States against domestic political considerations. Kissinger’s ability to put the reader in the minds of Chinese officials is the aspect of the book that will likely be the most enticing to current and future diplomats dealing with China.

Keck ends his review with an analysis of the current battle between Republican Party’s two main foreign policy schools: Realists vs. Neoconservatives. Keck is more sympathetic to Kissinger’s realism-based view of a rising China, arguing that at this moment, it provides the ‘best prospects for peace’.

I enjoyed my ‘China’s Rise’ morning of nerdy reading, now it’s your turn. Get to those articles!

There is a new urgency for a renewed American commitment to international order building. The Arab world is embroiled in turmoil, but this is only part of a larger global drama of crisis and transformation that includes the world economy’s struggle to find a path to stable growth, conflicts driven by resource scarcity, looming environmental threats, and the rise of developing countries—India, Brazil, and particularly China—into the ranks of the great powers. Even today, amidst these grand shifts in the global system, the United States remains the critical player in the rebuilding of international order, and three broad tasks confront it: It must integrate the rising powers into that order, ensuring continuity; it must make sure that China has the right incentives and opportunities to participate; and it must forge a “milieu-based” grand strategy that structures the general international environment in ways that are congenial to its long-term security.

However, Ikenberry is confident that not only can the current liberal order handle these changing times, but that it is still the best bet for a positive outcome for all involved, including China. Ikenberry spends about a third of the piece detailing how a rising autocratic China will challenge the modern system led by the United States, but concludes that the Middle Kingdom has already seen the fruits of the current order and with careful management can be integrated further:

Three features of this Western-oriented system are particularly relevant to how China makes decisions about whether to join or oppose it. The first relates to the rules and institutions of the capitalist world economy. More so than the imperial systems of the past, the liberal international order is built around rules and norms of nondiscrimination and market openness, creating conditions for rising states to participate within the order and advance their expanding economic and political goals within it. Across history, international orders have varied widely in terms of whether the material benefits that are generated accrue disproportionately to the leading state or whether they are more widely shared. In the Western system, the barriers to economic entry are low and the potential benefits are high. China has already discovered the massive economic returns that are possible through operating within this open market system.

Together, these features of evolving liberal international order give it an unusual capacity to accommodate rising powers.

Ikenberry lays out in further detail how China’s rise can be peaceful and beneficial for nearly all involved. Ikenberry concludes his article with various recommendations as to how the United States can help reinvigorate the liberal world order, but some of his recommendations are facing headwinds. For instance, he strongly advocates the building or rebuilding of security alliances with NATO as a prime example. Unfortunately, NATO is not the best example for a coherent, effective alliance at the moment and its future seems more bleak than bright. In fact, Ikenberry says that in return for a downgrade in American decision making power, the other members could provide more ‘manpower, logistics, and other types of support—in wider theaters of action’. According to Secretary Gates, these are the exact substances that the European side of NATO is currently lacking. Secondly, Ikenberry argues that the United Nations’ stature needs to be strengthened, another tall order.

Though Ikenberry has more faith in the tenets of international law and institutions than I do, his framework for a liberal, capitalist world led by the United States is one I firmly believe is the world’s best bet for prosperity and peace. The challenges it faces are well-known and formidable, but it has so far shown itself to be the most resilient system yet.

Kissinger’s secret trip to Beijing on July 9, 1971

So my team set off to Beijing via Saigon, Bangkok, New Delhi and Rawalpindi on an announced fact-finding journey on behalf of the president. My party included a broader set of American officials, as well as a core group destined for Beijing—myself, as national security adviser, three aides and two Secret Service agents. The dramatic denouement required us to go through tiring stops at each city designed to be so boringly matter-of-fact that the media would stop tracking our movements. In Rawalpindi, we disappeared for 48 hours for an ostensible rest (I had feigned illness) in a Pakistani hill station in the foothills of the Himalayas—but our real destination was Beijing. In Washington, only the president and Col. (later Gen.) Alexander Haig, my top aide, knew our actual mission.

When the American delegation arrived in Beijing on July 9, 1971, we had experienced the subtlety of Chinese communication but not the way Beijing conducted actual negotiations, still less the Chinese style of receiving visitors…

Strain was nowhere apparent in the Chinese reception of the secret visit or during the dialogue that followed. In all the preliminary maneuvers, we had been sometimes puzzled by the erratic pauses between their messages, which we assumed had something to do with the Cultural Revolution. Nothing now seemed to disturb the serene aplomb of our hosts, who acted as if welcoming the special emissary of the American president for the first time in the history of the People’s Republic of China was the most natural occurrence.

This is a great example of how individual people and personalities can affect international politics. The US-China rapprochement has power politics written all over it, but Nixon’s staunch anti-Communist background and his placement of Kissinger, an academic from the Realist school of international relations and history, were key elements in this dramatic geopolitical reversal. Kissinger went on to discuss President Nixon’s trip to China:

President Nixon’s visit to China February, 1972

Our hosts made up for the missing demonstrations by inviting Nixon to a meeting with Mao within hours of our arrival. “Inviting” is not the precise word for how meetings with Mao occurred. Appointments were never scheduled; they came about as if events of nature. They were echoes of emperors granting audiences.

The first indication of Mao’s invitation to Nixon occurred when, shortly after our arrival, I received word that Zhou needed to see me in a reception room. He informed me that “Chairman Mao would like to see the President.” To avoid the impression that Nixon was being summoned, I raised some technical issues about the order of events at the evening banquet. Uncharacteristically impatient, Zhou responded: “Since the Chairman is inviting him, he wants to see him fairly soon.” In welcoming Nixon at the very outset of his visit, Mao was signaling his authoritative endorsement to domestic and international audiences before talks had even begun. Accompanied by Zhou, we set off for Mao’s residence in Chinese cars.

Mao’s residence was approached through a wide gate on the east–west axis carved from where the ancient city walls stood before the Communist revolution. Inside the Imperial City, the road hugged a lake, on the other side of which stood a series of residences for high officials. All had been built in the days of Sino-Soviet friendship and reflected the heavy Stalinist style of the period. Mao’s residence appeared no different, though it stood slightly apart from the others. There were no visible guards or other appurtenances of power. A small anteroom was almost completely dominated by a Ping-Pong table…

…Mao rose from an armchair in the middle of a semicircle of armchairs with an attendant close by to steady him if necessary. We learned later that he had suffered a debilitating series of heart and lung ailments in the weeks before and that he had difficulty moving. Overcoming his handicaps, Mao exuded an extraordinary willpower and determination. He took Nixon’s hands in both of his and showered his most benevolent smile on him. The picture appeared in all the Chinese newspapers.

Mao and Nixon, wow. Would like to be a fly on that wall. Kissinger has more to tell than just of stories past regarding the Middle Kingdom. He, I believe accurately, contrasts the Chinese worldview with that of the US/West:

China’s World Outlook

In general, Chinese statesmanship exhibits a tendency to view the entire strategic landscape as part of a single whole: good and evil, near and far, strength and weakness, past and future all interrelated. In contrast to the Western approach of treating history as a process of modernity achieving a series of absolute victories over evil and backwardness, the traditional Chinese view of history emphasized a cyclical process of decay and rectification, in which nature and the world could be understood but not completely mastered.

For China’s classical sages, the world could never be conquered; wise rulers could hope only to harmonize with its trends. There was no New World to populate, no redemption awaiting mankind on distant shores. The promised land was China, and the Chinese were already there. The blessings of the Middle Kingdom’s culture might theoretically be extended, by China’s superior example, to the foreigners on the empire’s periphery. But there was no glory to be found in venturing across the seas to convert “heathens” to Chinese ways; the customs of the Celestial Dynasty were plainly beyond the attainment of the far barbarians.

If Kissinger is correct, then the inordinate fear of the coming Chinese century held by the American public is overly pessimistic to say the least. China may be a global force economically and will attempt to gain greater control over East Asia, but it is likely that their ambitions will not go much further. This of course can be countered by China’s encroachments in Latin America, Africa, the Middle East, Central Asia, etc. and by their strong efforts to grow a blue water navy. In short, I believe Kissinger’s view of a Chinese cyclical view to be mostly accurate, but no one knows exactly how this current leadership cadre will lead what is a country growing extremely fast in a world much different than the times of China’s last empires.

Lastly, Kissinger paints the current situation in a pragmatic, realist light:

US-China Power Politics

The question ultimately comes down to what the U.S. and China can realistically ask of each other. An explicit American project to organize Asia on the basis of containing China or creating a bloc of democratic states for an ideological crusade is unlikely to succeed—in part because China is an indispensable trading partner for most of its neighbors. By the same token, a Chinese attempt to exclude America from Asian economic and security affairs will similarly meet serious resistance from almost all other Asian states, which fear the consequences of a region dominated by a single power.

The appropriate label for the Sino-American relationship is less partnership than “co-evolution.” It means that both countries pursue their domestic imperatives, cooperating where possible, and adjust their relations to minimize conflict. Neither side endorses all the aims of the other or presumes a total identity of interests, but both sides seek to identify and develop complementary interests.

A little like; ‘You don’t step on my toes, and I won’t step on yours’. This of course is easier said than done and sometimes someone’s toes finds themselves in precarious situations. Kissinger’s portrayal is sound though: Attempting to contain China with an ‘ideological crusade’ is the wrong strategy for the US and China meet with great resistance if it seriously attempts to kick the US out of East Asia. The relationship will have to be carefully managed to say the least. Developing……for the next few decades.