New Orleans: A Geopolitical Prize

By George Friedman

The American political system was founded in Philadelphia, but the American nation was built on the vast farmlands that stretch from the Alleghenies to the Rockies. That farmland produced the wealth that funded American industrialization: It permitted the formation of a class of small landholders who, amazingly, could produce more than they could consume. They could sell their excess crops in the east and in Europe and save that money, which eventually became the founding capital of American industry.

But it was not the extraordinary land nor the farmers and ranchers who alone set the process in motion. Rather, it was geography -- the extraordinary system of rivers that flowed through the Midwest and allowed them to ship their surplus to the rest of the world. All of the rivers flowed into one -- the Mississippi -- and the Mississippi flowed to the ports in and around one city: New Orleans. It was in New Orleans that the barges from upstream were unloaded and their cargos stored, sold and reloaded on ocean-going vessels. Until last Sunday, New Orleans was, in many ways, the pivot of the American economy.

For that reason, the Battle of New Orleans in January 1815 was a key moment in American history. Even though the battle occurred after the War of 1812 was over, had the British taken New Orleans, we suspect they wouldn't have given it back. Without New Orleans, the entire Louisiana Purchase would have been valueless to the United States. Or, to state it more precisely, the British would control the region because, at the end of the day, the value of the Purchase was the land and the rivers - which all converged on the Mississippi and the ultimate port of New Orleans. The hero of the battle was Andrew Jackson, and when he became president, his obsession with Texas had much to do with keeping the Mexicans away from New Orleans.

During the Cold War, a macabre topic of discussion among bored graduate students who studied such things was this: If the Soviets could destroy one city with a large nuclear device, which would it be? The usual answers were Washington or New York. For me, the answer was simple: New Orleans. If the Mississippi River was shut to traffic, then the foundations of the economy would be shattered. The industrial minerals needed in the factories wouldn't come in, and the agricultural wealth wouldn't flow out. Alternative routes really weren't available. The Germans knew it too: A U-boat campaign occurred near the mouth of the Mississippi during World War II. Both the Germans and Stratfor have stood with Andy Jackson: New Orleans was the prize.

Last Sunday, nature took out New Orleans almost as surely as a nuclear strike. Hurricane Katrina's geopolitical effect was not, in many ways, distinguishable from a mushroom cloud. The key exit from North America was closed. The petrochemical industry, which has become an added value to the region since Jackson's days, was at risk. The navigability of the Mississippi south of New Orleans was a question mark. New Orleans as a city and as a port complex had ceased to exist, and it was not clear that it could recover.

The Ports of South Louisiana and New Orleans, which run north and south of the city, are as important today as at any point during the history of the republic. On its own merit, POSL is the largest port in the United States by tonnage and the fifth-largest in the world. It exports more than 52 million tons a year, of which more than half are agricultural products -- corn, soybeans and so on. A large proportion of U.S. agriculture flows out of the port. Almost as much cargo, nearly 17 million tons, comes in through the port -- including not only crude oil, but chemicals and fertilizers, coal, concrete and so on.

A simple way to think about the New Orleans port complex is that it is where the bulk commodities of agriculture go out to the world and the bulk commodities of industrialism come in. The commodity chain of the global food industry starts here, as does that of American industrialism. If these facilities are gone, more than the price of goods shifts: The very physical structure of the global economy would have to be reshaped. Consider the impact to the U.S. auto industry if steel doesn't come up the river, or the effect on global food supplies if U.S. corn and soybeans don't get to the markets.

The problem is that there are no good shipping alternatives. River transport is cheap, and most of the commodities we are discussing have low value-to-weight ratios. The U.S. transport system was built on the assumption that these commodities would travel to and from New Orleans by barge, where they would be loaded on ships or offloaded. Apart from port capacity elsewhere in the United States, there aren't enough trucks or rail cars to handle the long-distance hauling of these enormous quantities -- assuming for the moment that the economics could be managed, which they can't be.

The focus in the media has been on the oil industry in Louisiana and Mississippi. This is not a trivial question, but in a certain sense, it is dwarfed by the shipping issue. First, Louisiana is the source of about 15 percent of U.S.-produced petroleum, much of it from the Gulf. The local refineries are critical to American infrastructure. Were all of these facilities to be lost, the effect on the price of oil worldwide would be extraordinarily painful. If the river itself became unnavigable or if the ports are no longer functioning, however, the impact to the wider economy would be significantly more severe. In a sense, there is more flexibility in oil than in the physical transport of these other commodities.

There is clearly good news as information comes in. By all accounts, the Louisiana Offshore Oil Port, which services supertankers in the Gulf, is intact. Port Fourchon, which is the center of extraction operations in the Gulf, has sustained damage but is recoverable. The status of the oil platforms is unclear and it is not known what the underwater systems look like, but on the surface, the damage - though not trivial -- is manageable.

The news on the river is also far better than would have been expected on Sunday. The river has not changed its course. No major levees containing the river have burst. The Mississippi apparently has not silted up to such an extent that massive dredging would be required to render it navigable. Even the port facilities, although apparently damaged in many places and destroyed in few, are still there. The river, as transport corridor, has not been lost.

What has been lost is the city of New Orleans and many of the residential suburban areas around it. The population has fled, leaving behind a relatively small number of people in desperate straits. Some are dead, others are dying, and the magnitude of the situation dwarfs the resources required to ameliorate their condition. But it is not the population that is trapped in New Orleans that is of geopolitical significance: It is the population that has left and has nowhere to return to.

The oil fields, pipelines and ports required a skilled workforce in order to operate. That workforce requires homes. They require stores to buy food and other supplies. Hospitals and doctors. Schools for their children. In other words, in order to operate the facilities critical to the United States, you need a workforce to do it -- and that workforce is gone. Unlike in other disasters, that workforce cannot return to the region because they have no place to live. New Orleans is gone, and the metropolitan area surrounding New Orleans is either gone or so badly damaged that it will not be inhabitable for a long time.

It is possible to jury-rig around this problem for a short time. But the fact is that those who have left the area have gone to live with relatives and friends. Those who had the ability to leave also had networks of relationships and resources to manage their exile. But those resources are not infinite -- and as it becomes apparent that these people will not be returning to New Orleans any time soon, they will be enrolling their children in new schools, finding new jobs, finding new accommodations. If they have any insurance money coming, they will collect it. If they have none, then -- whatever emotional connections they may have to their home -- their economic connection to it has been severed. In a very short time, these people will be making decisions that will start to reshape population and workforce patterns in the region.

A city is a complex and ongoing process - one that requires physical infrastructure to support the people who live in it and people to operate that physical infrastructure. We don't simply mean power plants or sewage treatment facilities, although they are critical. Someone has to be able to sell a bottle of milk or a new shirt. Someone has to be able to repair a car or do surgery. And the people who do those things, along with the infrastructure that supports them, are gone -- and they are not coming back anytime soon.

It is in this sense, then, that it seems almost as if a nuclear weapon went off in New Orleans. The people mostly have fled rather than died, but they are gone. Not all of the facilities are destroyed, but most are. It appears to us that New Orleans and its environs have passed the point of recoverability. The area can recover, to be sure, but only with the commitment of massive resources from outside -- and those resources would always be at risk to another Katrina.

The displacement of population is the crisis that New Orleans faces. It is also a national crisis, because the largest port in the United States cannot function without a city around it. The physical and business processes of a port cannot occur in a ghost town, and right now, that is what New Orleans is. It is not about the facilities, and it is not about the oil. It is about the loss of a city's population and the paralysis of the largest port in the United States.

Let's go back to the beginning. The United States historically has depended on the Mississippi and its tributaries for transport. Barges navigate the river. Ships go on the ocean. The barges must offload to the ships and vice versa. There must be a facility to empower this exchange. It is also the facility where goods are stored in transit. Without this port, the river can't be used. Protecting that port has been, from the time of the Louisiana Purchase, a fundamental national security issue for the United States.

Katrina has taken out the port -- not by destroying the facilities, but by rendering the area uninhabited and potentially uninhabitable. That means that even if the Mississippi remains navigable, the absence of a port near the mouth of the river makes the Mississippi enormously less useful than it was. For these reasons, the United States has lost not only its biggest port complex, but also the utility of its river transport system -- the foundation of the entire American transport system. There are some substitutes, but none with sufficient capacity to solve the problem.

It follows from this that the port will have to be revived and, one would assume, the city as well. The ports around New Orleans are located as far north as they can be and still be accessed by ocean-going vessels. The need for ships to be able to pass each other in the waterways, which narrow to the north, adds to the problem. Besides, the Highway 190 bridge in Baton Rouge blocks the river going north. New Orleans is where it is for a reason: The United States needs a city right there.

New Orleans is not optional for the United States' commercial infrastructure. It is a terrible place for a city to be located, but exactly the place where a city must exist. With that as a given, a city will return there because the alternatives are too devastating. The harvest is coming, and that means that the port will have to be opened soon. As in Iraq, premiums will be paid to people prepared to endure the hardships of working in New Orleans. But in the end, the city will return because it has to.

Geopolitics is the stuff of permanent geographical realities and the way they interact with political life. Geopolitics created New Orleans. Geopolitics caused American presidents to obsess over its safety. And geopolitics will force the city's resurrection, even if it is in the worst imaginable place.

The Banking Problems in China
By Bedlam Asset Management
7/27/2005

 Remember Golmud, and mass hysteria

High up on the Tibetan plateau at 10,000 feet lies the City of Golmud, isolated even by the standards of that barren land. With no airport and at least 16 hours from the nearest sizeable town by the fastest possible transport, the Han Chinese immigrants (imported to colonise the once free country of Tibet) of this fair city take their pleasures where they can. One is to leave as soon as possible, made difficult by China's strict internal passport controls. More practical suggestions include a stroll to the local potash plant, the City's principle industry, a visit to the Cai Erhan Salt Lake, or to a giant half-empty dam (it doesn't rain much) or the hopelessly inefficient methanol plant. In this centrally planned, neo-Stalinist nirvana, you can also wander through a maze of poorly constructed monumental buildings while sipping Golmud's exciting variety of toxic waters, available from the many corner stand-pipes; for as in most of China, environmental controls are non-existent. Yet it is not for all these delights that the city of Golmud deserves its own special entry in the Financial Hall of Fame. It is because its entire banking system has just collapsed.

Run banker, run

In early May, the Kunlun Credit Co-operative in Golmud suffered a run by depositors, on rumours that its cash balance was down to $1,500. The panic quickly spread to the seven other credit co-operatives, whose tills were also empty, resulting in widespread rioting. All eight financial institutions closed down; by early June, the central Government belatedly embarked on a rescue plan. The cause for the collapse was simple. Prolonged fraud, on a massive scale, by senior bank officials operating hand in hand with Communist party cadres. According to official estimates, non-performing loans for the eight lenders were 96%; the worst had a capital adequacy ratio of minus 189% at the end of 2004. Almost all of these loans had been given to bank directors and senior apparatchiks (usually the same thing) at no interest cost, most of whom then disappeared. No arrests have been made. The total amount of money stolen was tiny, probably no more than $20 million; not an earth-shattering sum for China or anywhere else, merely the life savings of the entire population.

First there was GITIC

In 1998, the Guangdong International Trust & Investment Corporation (GITIC) collapsed. It was a specialist 'investment company' owned by the regional government of Guangdong province. The total debt was approximately $4.5 billion. The collapse was caused by poor investment decisions, astonishingly bad management and an impressive level of old fashioned theft. The Government came up with a ripping wheeze; to stuff foreign bankers with the losses. These lenders had become exuberant at China's explosive economic growth, following Deng Xiao Ping's 'liberal' reforms. They had naively decided that GITIC, as an enterprise owned by the regional government and controlled by the Central Bank of China, was government guaranteed and therefore represented a sovereign risk, i.e. very low. Like all bankers who have made bad decisions, they squealed like stuck pigs. Overnight foreign loans and investment dried up, as these foreign banks also tried to call in other outstanding loans. China then, as now, needs massive foreign investment, credit and expertise to increase its current income per capita from $1,100 to at least a second world level. The leadership quickly realised that foreign bankers and investors like to have their cake and eat it. As there were another 240 ITICs, of which over half were suffering the same problems, a bailout had to be arranged. As a consequence, around $170 billion worth of bad loans were transferred from these ITICs to various Chinese state banks. This was meant to be the end of the story.

Throwing good money after bad

The Government renewed its efforts to attract foreign investment. First the Chinese diaspora was encouraged to invest in joint ventures. This policy was soon expanded to western multinationals. They were more than willing to take advantage of cheap labour, minimal environmental controls, tax holidays and light legal controls. Their western

 

bankers were eager to see them replace their over-priced, often ill-educated workforces (with attitude problems) and fund a rapid relocation of their manufacturing to China. Domestic Chinese banks in turn far preferred lending to western companies, whose assets they could squeeze and seize if the need arose, rather than to local companies, where the assets were as likely as not owned by a bank director or a senior Communist party official.

Meanwhile, not only did the $170 billion of bad loans fester in the state banks' balance sheets, but grew like mushrooms. Both because China has been growing at anywhere between 7-12% p.a. over the last decade and because there is an almost total lack of social security or pension benefits, domestic savings are very high; thus national, city and regional banks all have vast deposits. Loan growth therefore exploded as these were doled out (so poor are bank controls, the system can hardly be classified as lending) to the thousands of bankrupt state owned enterprises to keep them afloat. In propping up these hopeless businesses, giving them sufficient money to allow them to 'pay interest' on earlier loans, the fiction that they are servicing their debts is maintained and therefore solvent. This has resulted in a remarkable balance sheet clean-up of the entire national banking system. In 2000, non-performing loans were officially nearly 40% of total loans, equal to more than $750 billion. No banking system at any time in history has survived for long with bad debts over 10%, let alone such a large number. Now they are allegedly a mere 20%.

The Government knew that excessive loan growth would be ultimately destructive and briefly tried to restrict new lending; but even this short slowdown resulted in too many businesses going to the wall. This was especially true of the small but vital private sector, whose access to loans was squeezed as banks cut them out first, in favour of foreigners and state enterprises. Given that China's primary economic problem is finding new employment for five million people every year, which can only come from the private sector, such a result was politically unacceptable. (Even so, private enterprise still has a problem accessing cheap credit, one of the reasons why China's main stock market index has halved since 2000.) So loan growth was again allowed to let rip, with good money thrown after bad. This has made a dangerous problem critical.

Scratch my back

Occasionally, weak attempts have been made to reform the financial system. In 2003 for example, and with considerable hullabaloo, the Bank of China fired 20 local bank managers (out of 3,000) for corruption. Care to bet that stopped the rot? More common are 'one-off' rescues, which repeat every few years. $45 billion was shelled out by the financial authorities in 2003 to prop up the Bank of China and the China Construction Bank, followed by $30 billion into ICBC. Even by western standards, these are simply huge numbers (Barings couldn't even lose a billion, despite trying very hard). All these reforms and bail-outs fail for one reason, the core problem of the Guangxi system.

Guangxi (or connections) is not just having a Scottish Cabinet ruling England and Wales, or Enarques, all of whom attended the same two schools, running the French civil service. It is more subtle. It includes blood relatives and in-laws; it can extend to cousins of cousins, clans of the same name (China has only 100 proper surnames), people from your village or province and hopefully, senior politicians for whom one of your set once did a favour. It has been around for hundreds of years. Neither the Manchu nor Mongol rulers understood it or could break it. Guangxi has its strengths; it provides a support net for the weak and dispossessed. Very large personal networks on a national level can make the creation of new businesses and raising capital a remarkably smooth operation. It also embeds corruption, deeply. Thus any attempt at reform becomes mired and compromised. Government regulators find themselves having to pull the plug on their own connections, including perhaps their bosses or even worse, senior army officers and politicians. This is why so many of Hong Kong's listed 'red-chip' companies, run by wholly unqualified children of senior officials, were able to get all the funding, licences and assets they wanted in record time. Another more recent example of a Guangxi in operation took place in July this year; an order from the Government that the state-owned commercial banks must lend $1.2 billion to around half of the country's 130 securities firms which in practice have gone bust. Each has a major political connection. It is into this hopeless financial morass that western bankers have now decided to invest.

Mass hysteria

When every major bank has the same brilliant idea at the same time, shareholders should start to attend AGMs to ask serious questions; depositors should be very nervous. One good example of western banks having the same disastrously clever idea at the same time was between 1993 and 1996. In July 1997, a banking crisis started to roll across Asia. This did not seem to be a western bank problem, until it became apparent the BIS reporting banks* (a quasi-regulatory body which includes every significant or sound bank in the world) had loaned the equivalent of their entire Tier 1 capital (i.e. all their reserves, plus) to just four small countries - Korea, Thailand, Indonesia and Malaysia. They had no natural business in these nations but wanted to take advantage of superior growth and higher interest rates. The collapse of the banking systems in these countries, whose joint GDP was then less than that of Germany, caused a domino effect into Russia, South Africa, Latin America and then LTCM.

It was a very close run thing; a global banking crisis was only narrowly averted.

Today, most leading western banks have agreed that they must be in China, seemingly irrespective of the price, because of its rapid growth. They cannot resist the lure of potentially 1.3 billion savers and borrowers. They have swallowed the myth that the balance sheets of China's financial institutions have been cleaned up. Western banks are now shelving out considerable sums for the tiniest toehold in the China market. Not surprisingly, one of the earliest players was Hong Kong's Hang Seng Bank. In 2003, together with the finance arm of the World Bank and the Government Investment Corporation of Singapore, it plonked down $324 million for a 24.9% stake in China's Industrial Bank. Its parent, the better known HSBC, subsequently shelled out $1.75 billion for a 19.9% stake in the Bank of Communications. Both these two banks have an economic imperative and a level of knowledge of how to work in difficult Asian countries, which means they might even make a small return on capital, one day. For almost all other major banks, there must be considerable doubt. Bank of America is paying $3 billion for a 9% stake in China Construction Bank; Dutch-based ING Groep bought a 19.9% stake in the Bank of Beijing for €166 million. Newbridge Capital of the US bought 18% in the Shenzhen Development Bank. There is now hardly a major foreign bank not sniffing around Chinese banks and assets in one form or another. Those who have either been snoogling or have stated they are looking at major bank or asset deals include the Commonwealth Bank of Australia, Britain's Standard Chartered Bank, JP Morgan, Credit Agricole, Morgan Stanley, Bank of Nova Scotia and many, many more. It is a global herd.

The reasons given are almost identical; to quote Bank of America's chairman, 'It makes sense if you are looking to tap into economic growth'. Walter Wriston, former head of Citibank, won financial immortality with a similar comment - 'countries don't go bust'. Citibank almost folded two years later when Mexico suffered one of its perennial meltdowns. A near-term reason may be more prosaic; fees. China is desperate to resolve its hideous domestic bad debt problem through the use of foreign capital. It can see no other way of solving its banking crisis except by importing more and more capital. For these foreigners, there is the delicious personal prospect of huge fees and bonuses. The current flotation plans for myriad Chinese banks and insurance companies could produce, assuming all go ahead, underwriting and placement fees of over a billion dollars by the end of 2006. Approximately half of this amount will drop straight into the hands of the executives who engineered these deals; by the time the solids hit the air conditioning, they will have long moved on - to retirement or other banks - because of their international expertise.

All these foreign banks can only buy minority stakes, not control, as Chinese law bars this. All claim to be playing the long game, that their expertise will help sharpen up the domestic banks, i.e. that they can break the thousand year old Guangxi system. None to date have had a return on capital above its cost. Even more wonderful, they actually believe they know the true balance sheets of the banks they are buying. 1,500 years ago, the Chinese not only invented accounting, they then invented quadruple accounting; a true set for limited internal use, another for the government, one for the investors and then one for their wives. We are suspicious that mustard-keen western MBAs, whose sights are fixed on 1.3 billion consumers and their near-term bonuses, rather than the $750 billion worth of bad debts in the system, can see through these multiple fictions.

Little Golmud and its recent financial meltdown will soon slip back into oblivion. Every storm starts with a small cloud. That China is wandering into a banking crisis is a certainty; we don't know when it will start, or how, but it is inevitable. Remember Golmud.

Regards
Bedlam Asset Management

 

The Geopolitics of Katrina

The Port of Southern Louisiana is the fifth-largest port in the world in terms of tonnage, and the largest port in the United States. The only global ports larger are Singapore, Rotterdam, Shanghai and Hong Kong. It is bigger than Houston, Chiba and Nagoya, Antwerp and New York/New Jersey. It is a key link in U.S. imports and exports and critical to the global economy.

The Port of Southern Louisiana stretches up and down the Mississippi River for about 50 miles, running north and south of New Orleans from St. James to St. Charles Parish. It is the key port for the export of grains to the rest of the world -- corn, soybeans, wheat and animal feed. Midwestern farmers and global consumers depend on those exports. The United States imports crude oil, petrochemicals, steel, fertilizers and ores through the port. Fifteen percent of all U.S. exports by value go through the port. Nearly half of the exports go to Europe.

The Port of Southern Louisiana is a river port. It depends on the navigability of the Mississippi River. The Mississippi is notorious for changing its course, and in southern Louisiana -- indeed along much of its length -- levees both protect the land from its water and maintain its course and navigability. Dredging and other maintenance are constant and necessary to maintain its navigability. It is fragile.

If New Orleans is hit, the Port of Southern Louisiana, by definition, also will be hit. No one can predict the precise course of the storm or its consequences. However, if we speculate on worse-case scenarios the following consequences jump out:

·  The port might become in whole or part unusable if levees burst. If the damage to the river and port facilities could not be repaired within 30 days when the U.S. harvests are at their peak, the effect on global agricultural prices could be substantial.

·  There is a large refinery at Belle Chasse. It is the only refinery that is seriously threatened by the storm, but if it were to be inundated, 250,000 barrels per day would go off line. Moreover, the threat of environmental danger would be substantial.

·  About 2 percent of world crude production and roughly 25 percent of U.S.-produced crude comes from the Gulf of Mexico and already is affected by Katrina. Platforms in the path of Katrina have been evacuated but others continue pumping. If this follows normal patterns, most production will be back on line within hours or days. However, if a Category 5 hurricane (of which there have only been three others in history) has a different effect, the damage could be longer lasting. Depending on the effect on the Port of Southern Louisiana, the ability to ship could be affected.

·  A narrow, two-lane highway that handles approximately 10,000 vehicles a day, is used for transport of cargo and petroleum products and provides port access for thousands of employees is threatened with closure. A closure of as long as two weeks could rapidly push gasoline prices higher.

At a time when oil prices are in the mid-60-dollar range and starting to hurt, the hurricane has an obvious effect. However, it must be borne in mind that the Mississippi remains a key American shipping route, particularly for the export and import of a variety of primary commodities from grain to oil, as well as steel and rubber. Andrew Jackson fought hard to keep the British from taking New Orleans because he knew it was the main artery for U.S. trade with the world. He was right and its role has not changed since then.

Stratfor

U.S.-Indian Relations and the Geopolitical System

By George Friedman

Indian Prime Minister Manmohan Singh is in Washington and has addressed a joint session of Congress. Most visiting heads of government don't get that privilege, but Singh is no ordinary leader. The Indo-American relationship is emerging as one of the foundations of the global system. For the United States, India -- particularly since 9/11 -- has come to represent a strategic partner in the U.S.-jihadist war: By its very existence as a U.S. ally, it serves to keep the pressure for cooperation very high on rival Pakistan. For India, the United States has come to represent an alternative to its former relationship with the Soviet Union, which helped to guarantee India's regional interests. Thus, Singh's visit, while dealing with a range of the normal minutiae of international relations, represents confirmation that something of fundamental importance has happened.

Unlike many summits, this particular one has had the look, feel and substance of a significant event. Foreign leaders do not usually get to address Congress. The entire tone of the meetings implied a significant turning point. But in this case, the concrete agreements were as important as the symbolism: Significant deals were signed.

The most publicly significant was a deal giving the Indians access to American nuclear technology for civilian uses. India became a nuclear power in 1974, against strong U.S. opposition. The decision to give India nuclear technology -- even for civilian uses -- marks a sea change in American thinking about India's nuclear capability. To be more precise, it marks the culmination of a sea change. Washington used a series of severe, near-nuclear crises between India and Pakistan following the Sept. 11 attacks to leverage Islamabad toward greater cooperation with the United States. It was clear then that the United States was changing its view of India "on the fly." This new agreement represents a public affirmation that Washington regards India's nuclear capabilities as non-threatening to American interests and, indeed, as a potential asset.

In agreeing to increase India's nuclear technology base, albeit only for civilian uses and under international supervision, the United States is affirming that a special relationship exists with India.

At the same time that this public agreement was being reached, official leaks from the Pentagon said that India would begin purchasing up to $5 billion worth of conventional weapons, once Congress approves the deal. This requires an act of Congress because current law on non-proliferation bars the sale of a wide array of military technology to countries that have acquired nuclear weapons -- specifically focusing on any technology that might be useful to a nuclear weapons program. Since the technologies that are potentially useful are amazingly diverse, large swathes of technology are excluded from sale. Should Congress approve the bill, it would place India in a position similar to that of Israel (save that Israel doesn't acknowledge publicly that it has nuclear weapons).

The things being sold to India are also interesting. For example, India will be allowed to purchase Aegis technology, which is designed to protect naval vessels -- and battle groups -- from anti-ship missiles. So far, only Japan has acquired the technology, partly because of its cost. In addition, New Delhi will be able to purchase anti-submarine patrol aircraft. The United States, which until a few years ago regarded the Indian naval build-up -- based on Soviet technology -- as a threat to U.S. control of sea lanes in the Indian Ocean, has now completely reversed its posture. It is selling New Delhi naval technology that will allow the Indians to fulfill one of their key strategic objectives, which is to be able to control regional sea lanes. The United States would not be providing this technology without having achieved a far-reaching strategic agreement with New Delhi.

This, by the way, has the Pakistanis worried. Islamabad clearly understands that its status as Washington's ally in the U.S.-jihadist war will go only so far in terms of duration and dividends for Pakistan. In other words, while India gets a long-term strategic relationship with the United States, Pakistan's relationship is viewed as short-term and tactical.

To understand the major shift taking place between Washington and New Delhi, it is important to understand the geopolitical context that created it. Almost from the beginning, there were tensions between the United States and India. India's formal position was non-alignment between the Soviet Union and the United States. It was one of the founders and leaders of the non-aligned movement. Apart from its formal position, India had fundamental problems with the geopolitical stance of the United States, which during the Cold War was heavily focused on developing Muslim allies.

The primary interest of the United States was the containment of the Soviet Union. This inevitably caused Washington to focus on two predominantly Muslim countries that bordered the Soviet Union: Turkey and Iran. American strategy could not work if either of these nations were not allied with the United States, and Washington did everything it could to assure their alignment, including engineering a coup in Iran in 1953. The focus on Muslim countries extended beyond these two. The Americans did not want their rear and flanks turned by the Soviets; the United States and Britain, therefore, focused on both Syria and Iraq as well as on the Arabian Peninsula. It is important to recall that during the 1950s the United States had rather cool relations with Israel; it was pursuing a pro-Muslim strategy out of geopolitical necessity.

During the 1950s, the Indians were the ones with a Muslim problem. The partition of India into Muslim- and Hindu-majority nations had created Pakistan, which represented India's primary national security concern. In looking at India's geography, it should be noted that in many ways, India is an island. Its northern boundary essentially consists of the Himalayas, impassable for any substantial military force. Its eastern frontier faces tropical jungles. Most of its borders consist of ocean. Only to the west, where Pakistan lies, did there exist a strategic threat. It is true that what is today Bangladesh was part of Pakistan in those years, but it never posed a strategic threat. As the crow flies, the Pakistani border is only a couple of hundred miles from Delhi and Bombay; that was not a trivial concern.

The United States was pursuing the Muslim world. The Indians saw themselves as threatened by the Muslim world. U.S. and Indian interests, already strained by ideology, diverged fundamentally. India needed a counterweight to the United States and found it in the Soviet Union. Though it never became Communist, India became an ally of the Soviets. The Indians built their armed forces on a foundation of Soviet technology, and their highly bureaucratized economy found some commonality with the Soviets.

From a purely strategic point of view, the Indo-Soviet relationship did not mean all that much. Even after the Sino-Soviet split, the direct impact that India or the Soviets could have on each other's strategic situation was severely limited. India was never the military counterweight to China that the Soviets needed -- not because its forces couldn't challenge the Chinese, but because geography prevented the two forces from coming to grips with each other. People speak of Sino-Indian competition -- and there was a war (though not one that could threaten the survival of either nation) between India and China in 1962 in the Himalayas -- but the fact is that the two countries could be ten thousand miles apart for the extent to which geography permits any meaningful interaction. India's isolation limited the significance of its confrontation with the Soviets. The value of the relationship was marginalized by geography.

India therefore became marginal to the international system. Its major point of contact was with Pakistan, with which it had fought a series of wars -- major ones in 1948, 1965 and 1971 -- had serious territorial issues and deep distrust. Pakistan was supported by the United States and China, the two anti-Soviet powers in the 1970s and 1980s. This was partly due to India's relationship with the Soviets and partly due to American interests in the Islamic world.

Marginalization is the key concept for understanding India's position in the world prior to 2001. Geography prevented it from having substantial interaction with the great powers. Its point of contact, Pakistan, was of some importance, but not decisive importance. Prior to becoming a nuclear power, India had only one recourse: naval power. But its economy would not support a full-blooded fleet-building program. Its strength was in its army, but that army could not be projected anywhere.

Its economy was also marginalized. Built on a socialist model that took the worst from Soviet planning and Western markets, the Indian economy isolated itself by laws that severely limited outside investment. Its infrastructure did not develop and, while several key industries -- pharmaceuticals and electronics -- emerged, this never created the fabric of what might be called a national economy. India was a huge, fragmented country, on the margins of the international system. Its friendship with the Soviets and its enmity with the United States were tepid on all sides.

Then came the 9/11 strikes, and the American relationship with the Islamic world was transformed almost overnight. Suddenly, Pakistan became a critical piece of the United States' long-term war plan, and therefore India became an extremely valuable asset. The Indians understood two things. First, that as marginalized as they had been in the Cold War, they had become irrelevant to the international system in the post-Cold War period prior to 9/11. Second, they understood that the U.S.-jihadist war could become India's entry into the broader international system.

U.S.-Indian collaboration began intensely shortly after 9/11. Part of it consisted of a mutual interest in manipulating Pakistan; part of it had broader implications. As the United States began to view the Muslim world as an unreliable and threatening entity, it started to see India in the same light as Israel. It was a potentially powerful ally that, in spite of its hostility to the Islamic world, or perhaps because of it, could be extremely useful. Long, complex negotiations ensued, leading up the present summit. The terms of endearment, so to speak, were defined. A range of issues on which the two sides could collaborate emerged.

A not-so-hidden issue at the summit in Washington was China. Sino-U.S. relations are deteriorating fairly rapidly. There was much speculation about India being an Asian counterweight to China. We have no idea what this means, since geographically China and India occupy two very different Asias. The United States doesn't need a nuclear counterweight to China, and China is very far from becoming a major naval power capable of projecting force outside of its regional waters. By that, we do not mean sailing into these waters, but fighting, winning battles and sailing home. The nuclear technology agreement that Singh obtained in Washington increases the likelihood that China is not going to project force west of Singapore. On the other hand, it was never likely to do so.

There is, however, another dimension to this. For a generation, China has been the place where hot money in search of high returns was destined. It was where the action was. It is no longer that place, except in the minds of the nostalgic and delusional. But India could well be. If one thinks of China in 1980, the notion that its bureaucracy, lack of infrastructure and a culture antithetical to rapid development would yield the economic powerhouse of 2000 would have been unthinkable. It was unthinkable.

India is in China's position of 1980. It has a mind-boggling bureaucracy, poor infrastructure and a culture antithetical to rapid development. At the same time, it has the basic materials that China built on. As the Sino-U.S. relationship deteriorates, India can be a counterweight to China -- not in a military sense, but in an economic sense. If the United States has an economic alternative to China for investment, Washington develops leverage in its talks with Beijing on a host of issues. China, after all, still courts investment -- even as the Chinese buy anything that isn't Chinese.

Another factor underscoring the significance of the shift in Indo-U.S. relations is New Delhi's relationship with Tehran. India's relations with Iran have always been a serious point of contention and concern for the United States. However, due to the situation in Iraq, tensions with New Delhi over this issue are on the decline. The United States and Iran at the moment are developing parallel interests, each with their own reasons to work together to ensure the success of the fledgling Shia-dominated government in Baghdad.

The Indo-American relationship did not develop out of the subjective good will of the leaders. The Sept. 11 attacks created a dynamic that couldn't be resisted, and that created a reality that the Bush-Singh summit confirmed. It doesn't transform the world, but it changes it fundamentally. India will come out of this a very different country, and the United States will look at the Indian Ocean Basin in a very different way.

The way of the dragon
 

Jun 23rd 2005
From The Economist Global Agenda

The state-controlled China National Offshore Oil Corporation has bid $18.5 billion for Unocal, an American energy company, in the latest sign that China is looking overseas for natural resources and brands. Controversially, acquisitive Chinese firms are getting a lot of help from their government

OTHER than capturing the mood of cold-war paranoia, the 1960s film “Battle Beneath the Earth” has little to recommend it. But the message that Communist China was set to take over America by sending an army through a set of tunnels dug beneath the Pacific Ocean played on popular fears. Nowadays it is China’s economic might that has the world in a tizzy, and the Chinese are coming armed with money to buy assets, not guns.

China’s biggest strike so far is an offer for Unocal, a California-based oil and gas firm. On Thursday June 23rd, the state-controlled China National Offshore Oil Corporation (CNOOC) made a cash bid of $18.5 billion for Unocal ($20.6 billion including assumed debt and a break-up fee), trumping a $18 billion share-and-cash offer (including the debt) from Chevron, America’s second-largest oil company. Opponents in America have based their hostility to CNOOC’s bid on national-security issues. The Chinese firm has promised to preserve American jobs and keep Unocal’s products on sale in the country to assuage nationalist sentiment. Unocal said it will evaluate the bid but that its board’s recommendation of Chevron’s offer “remains in effect”.

China’s move for Unocal neatly sums up the two forces driving the country’s ongoing bid to acquire foreign assets: the thirst for raw materials to feed and maintain its booming economy, and the desire to obtain western brands to help market Chinese exports.

Last year China’s economy grew by 9.5%, and the pace does not appear to be slowing much. The economy is in the throes of a gradual transition from state control to the free market. Much of Chinese industry is government-controlled, and some years ago China’s authorities concluded that to challenge the rest of the world they needed to build up to 50 of the country’s better firms into globally competitive multinationals—helping them along the way with tax breaks, free land and all-but-free financing through state-owned banks. The eventual aim was to create national champions that could take on the world’s leading companies while remaining under the watchful eye of the state.

To this end, Chinese firms have made deals to gain access to natural resources. Buying Unocal would give CNOOC fresh oil and gas reserves (many of which are located in Asia) at a time when energy prices are high and China’s appetite is strong. Last year Baosteel, China’s leading steelmaker, entered into joint-ventures in Australia and Brazil to assure supplies of iron ore. PetroChina and Sinopec, the two biggest state oil firms, have also shopped abroad. But this quest for commodities has not always proved successful. Last year China Minmetals, the country’s biggest base-metals firm, failed in a $7 billion attempted takeover of Canada’s Noranda, an ore producer. Fears that Minmetals still harbours ambitions spurred Canada’s government to introduce a bill this week intended to block foreign takeovers on national-security grounds.

As well as securing the natural resources necessary to keep output bubbling, Chinese firms are looking around the world for struggling but globally recognised brands. This is because Chinese companies, while enjoying cost advantages thanks to a vast pool of cheap labour, have an image problem. Foreign consumers think of Chinese goods as admirably cheap but lacking in quality. As Chinese firms move up the “value chain”, they are keen to buy foreign brands that they can attach to their more promising products.

Late last year Lenovo, China’s leading PC-maker, which is connected to the government through its ownership by the Chinese Academy of Science, bought the PC business of IBM for $1.75 billion. Under the terms of the deal, Lenovo acquired the right to use the IBM name on its computers for five years. And this week Haier, China’s leading appliance maker, teamed up with two American buy-out firms to bid $1.3 billion for Maytag in an effort to make a substantial move beyond China, where it has a market share of up to 70% for some products. The ailing American maker of Hoover vacuum cleaners had previously agreed to a $1.1 billion offer from a domestic private-equity firm. In early 2004, China’s TCL bought the television-making business of France’s Thomson, making it the world’s leading volume manufacturer of TV sets.

Undoubtedly, it is quicker (and possibly cheaper) to buy a well-known brand than to build one from scratch. But the Chinese are not throwing money at any and every firm with a well-known name. Shanghai Automotive Industry Corp (SAIC), which last year trumped a South Korean rival to buy Ssangyong, Korea’s fourth-largest carmaker, recently pulled out of a deal to buy MG Rover, a foundering British car company that has since folded. In fact, SAIC had apparently acquired much of the intellectual property that it wanted from Rover and was unwilling to foot the bill to keep the firm going. In this case, the Chinese were as keen to get their hands on useful technology as they were to secure the rights to a western brand.

The Chinese government’s coddling of its state-owned firms is another force behind the current wave of overseas expansion. While officials want to see markets develop at home, up to a point, they fear the fallout from the collapse of hundreds of large, communist-era basket-cases. So the government props these enterprises up with ultra-cheap loans through the banking system and other favours, which have the effect of creating overcapacity and nurturing unfair competition. This, in turn, pushes the more successful state firms, and private companies like Haier, to seek opportunities in markets abroad.

China’s favoured companies, with their access to cut-price funding, will usually be at an advantage compared with overseas rivals when bidding for assets, and may be prepared to pay over the odds. Critics suggest that CNOOC is paying too high a price for Unocal and that the money is coming from China’s government, which has let its desire to create global businesses cloud commercial logic. CNOOC has said it will borrow $16 billion from its government-owned parent and banks to finance the offer.

Shareholders of target firms like Unocal may well be pleased by this readiness to splash out, but their workers might worry. Jobs often go as Chinese buyers shift production to lower-cost plants at home. This fuels opposition to such takeovers in the targets’ countries. But for now at least, the spread of Chinese business around the world is set to continue.

What do yuant from us?
 

May 20th 2005
From The Economist Global Agenda

As protectionist sentiment grows in Europe and America, China faces increasing pressure to revalue its currency. Domestic financial considerations are also making a revaluation look more attractive. But the road to a freer regime for the yuan is full of potential pitfalls, and Beijing is reluctant to be seen caving in to foreign pressure

TO HEAR American and European officials talk, you might think China was flooding their countries with toxic waste, instead of affordable consumer goods. Both the European Commission and the American Congress have begun proceedings to protect their citizens from the threat of cheap Chinese textiles. Both are unhappy with the effect of China’s currency peg to the dollar—America because it makes inexpensive Chinese goods even cheaper, and Europe because the euro is having to bear the brunt of the dollar’s depreciation. On Tuesday May 17th, America’s Treasury gave warning that unless China relaxes its peg, it is likely to be classified as a currency manipulator. In Congress, a proposal is afoot to slap punitive tariffs on Chinese goods unless the yuan is revalued within six months. Such moves are sufficiently worrying that on Friday the official Xinhua news agency reported that China would impose export tariffs on its own textiles starting in June, presumably to ward off more draconian measures abroad.

While the political logic of tariffs is clear, the reasons for pressuring China to revalue are less so. China’s currency peg, at around 8.28 to the dollar, is widely believed to be keeping the yuan undervalued by 15-40%, making Chinese exports artificially cheap. But it also subsidises a great deal of America’s profligate spending. In order to maintain the peg, China is forced to buy loads of dollars, which are then dumped into US Treasury bonds, financing America’s hefty deficits. A sudden decline in Chinese demand for Treasuries would raise America’s borrowing costs, curbing Congress’s ability to dole out pork to constituents. Some economists fear that this would push interest rates up sharply enough to cause a sharp contraction in the debt markets (including the mortgages that are fuelling America’s housing boom) and the economy—though this is unlikely, since the Chinese government seems keen to ensure that any appreciation occurs gradually.

If it is hard to tell whether American politicians are just blustering to impress their constituents or really mean it, it is even harder to tell what effect their remarks are having. The markets are abuzz with talk of imminent yuan revaluation, but such hopes have surfaced many times before, and the Chinese government has so far disappointed. Last week the People’s Daily, an English-language Chinese paper, reported surprisingly specific plans to revalue the currency, only to quickly retract its story, claiming a translation error. However, some observers wondered if the publication had in fact been used by the Chinese government to test the waters.

Certainly, the head of China’s central bank has recently been making noises that sound an awful lot like “revaluation”. But other officials are reluctant to tamper with a peg that they perceive to be working well. This week Wen Jiabao, China’s prime minister, thundered that his country would not bow to outside pressure on the yuan. Indeed, many think that hotter rhetoric from American politicians will only make China delay any revaluation plans it is working on. Having enacted export tariffs in response to protectionist politicians on both sides of the Atlantic, China might now be even more reluctant to relax its peg, for fear of being seen buckling under foreign demands.

Revaluation certainly looks tricky for the Chinese government. It believes that for the sake of political and social stability, it needs 15m-20m new jobs a year. Increases at that level will be enough to absorb population growth, plus displaced workers from the agricultural sector and China’s ailing state-owned firms. And the export sector is seen as a crucial vehicle of job creation.

But this is not the only reason that Chinese politicians are reluctant to revalue. By some estimates, as much as three-quarters of China’s foreign-currency reserves are held in dollars; if the central bank allows the yuan to rise against the dollar, it will also in effect be allowing the value of its reserves to depreciate. Moreover, if slowing the flood of dollars that China’s central bank is pouring into American debt markets does cause those markets—and the American economy—to contract, China’s exporting firms will have worse problems than a more expensive yuan. And problems for those firms could translate into big trouble for China’s frail banking system.

On the other hand, revaluation has its advantages. In order to “sterilise” its foreign-currency operations, preventing them from causing domestic inflation, China’s central bank has been issuing domestic securities. These have been stuffed into the banking system, which may be reaching the limits of its ability to absorb such infusions. Revaluation would ease this problem.

It would also mean that monetary policy could focus more on controlling the money supply, less on maintaining the currency peg. With economic growth hovering close to double-digit levels, fears of an overheating economy, and the attending inflation, are coming to the fore. And because per-capita GDP is so low—only $1,226 in 2004—large swathes of the population are vulnerable to even small increases in inflation; price instability could quickly become political instability. But China’s capital controls and currency peg make monetary policy much harder to execute.

As pressures are growing at home, so they are mounting in America, where all those cheap goods, and cheap loans, are fuelling a buying binge that cannot last. America’s national savings rate has already plunged to razor-thin levels, and each passing month of spending more than they earn leaves households more vulnerable to a sharp rise in interest rates when the Chinese stop lending. Despite the immediate political fallout, it looks like both America and China would be better off taking their medicine now, rather than dragging things out in the hope that a miracle will intervene.

Don't expect too much

But even if China does revalue, it will not be the salvation that American politicians are praying for. First, it is highly unlikely that the yuan will be allowed to rise very far; even optimists expect a revaluation only in the range of 3-10%, which will still leave the currency seriously undervalued.

Moreover, the effects of a relaxed peg on America’s current-account deficit will be extremely modest. China accounts for less than one-tenth of America’s trade, so even a 10% revaluation would only reduce the trade-weighted value of the dollar by 1%—not enough to produce any noticeable change in America’s current account. Nor is it clear that even a big revaluation would help much. Morris Goldstein of the Institute for International Economics estimates that even a 25% revaluation would reduce the current-account deficit by less than 5%.

Nonetheless, China seems to be preparing the way for a slightly freer currency. This week it allowed some foreign currencies to be traded against each other for the first time in China. This is widely seen as a preparation for reform of the tightly controlled currency regime. And if a revaluation seems unlikely to please America’s protectionist politicians, it should nonetheless help to correct the imbalances caused by the gaping American current-account deficit, if only by weaning America’s spendthrift consumers—and government—off cheap Chinese credit. If the hour of reckoning is not quite at hand, it seems only a matter of time before China’s financial system, and America’s borrowers, begin to grow up.