WARFARE has been transformed by drones. Using pilotless aircraft armed with precision weapons America can kill its enemies—in, say, the Hindu Kush or Syria—with a click of a mouse. There is a similar shift in economic diplomacy, where Uncle Sam has perfected new weapons that exploit its power over the world’s financial plumbing and over the brainiest parts of the tech industry. In April these weapons were used in anger on big, important firms for the first time. The targets were Rusal, a Russian metals firm, and ZTE, a Chinese electronics company. The results have been devastating—and alarming.
In 1919 Woodrow Wilson called international sanctions a “silent, deadly remedy” and over the next 70 years America deployed them about 70 times, reckons Gary Hufbauer of the Peterson Institute. America achieved its geopolitical objectives only a third of the time, he says. But there was little doubt that it could meet its narrower goal of inflicting pain by halting trade with other countries and by freezing foreigners’ assets in America.
But by the 1990s globalisation had weakened America’s clout. Foreign firms had more countries to trade with. Multinationals saw fines from the authorities as a tolerable cost of doing business. The nadir was the Iraq oil-for-food programme in the 1990s, administered by the UN. Over 2,000 firms were suspected of making illegal payments to Saddam Hussein’s regime.
Everything changed after September 11th 2001. American officials realised they could use data and financial flows as a weapon, according to Juan Zarate, a former official, in his memoir “Treasury’s War”. The Patriot Act in 2001 allowed the Treasury to label foreign banks as threats to financial integrity and to ban them from the system for clearing dollar payments. In 2001-03 America won the right to peer into SWIFT, a formerly confidential global bank messaging system. Suddenly America could track its enemies. And it could make them radioactive to most counterparties, because any bank that touched them, even indirectly and with multiple degrees of separation, could be banned from clearing in dollars—which, if you run a cross-border bank, is fatal.
Between 2002 and 2008 the Treasury experimented with small fry. It brought to heel Victor Bout, an arms dealer; BDA, a bank in Macau that traded with North Korea; and Nauru, a Pacific island with a sideline in exotic finance. Since 2008 Western banks have been fined for breaking rules in the past, but not banned from dollar clearing. More recently Iran and Syria have faced new sanctions but they have few links with the global economy.
Last month, the stakes were raised. At the end of 2017 Rusal was one of the world’s largest aluminium producers, with an enterprise value of $18bn, controlled by Oleg Deripaska, an oligarch close to Vladimir Putin. Kapow! In April it was sanctioned as part of a package of measures against Russia. Rusal’s links to America are slight. It makes 14% of its sales there, does not typically use American banks and is listed in Hong Kong and Moscow (a related company, EN+, is listed in London).
The consequences have still been devastating. Many investors must sell their securities. Rusal may be unable to refinance its dollar debts. Global trading houses that buy its product have curtailed activities, as has Maersk, a shipping line. The London Metal Exchange has limited trading with Rusal. Credit-ratings agencies have withdrawn ratings. European clearing houses will not settle its securities. Its shares have dropped by 56% and its 2023 bonds trade at 45 cents on the dollar. Mr Deripaska is scrambling to sell down his indirect interest in Rusal to try and save it.
What about ZTE? At the end of last year it was the world’s fourth-biggest telecoms-equipment firm, with an enterprise value of $17bn, boasting a Chinese state firm as its anchor shareholder. It only makes around 15% of its sales in America. Bang! On April 16th the Commerce Department banned American firms from supplying it with components for seven years. ZTE had admitted trading with Iran and North Korea and then, in 2016 and 2017, it lied about the remedies it had put in place. ZTE’s shares have been suspended. The fallout will be severe. UBS, a bank, reckons that 80% of ZTE’s products rely on components from America, mainly cutting-edge semiconductors. Western banks and firms will be worried about coming into contact with it.
Companies that break the law or act in concert with autocratic governments do not deserve sympathy. But there are three, unsettling conclusions to draw from America’s first use of smart weapons against big foreign firms. First, any large company can be reached. No fewer than 2,000 big companies outside America issue dollar bonds, for example. Total dollar debt owed by firms outside America is over $5trn. Cross-border supply chains mean most firms rely on American tech components in some way.
Second, these powers could be misused, either for overtly political ends or because they are badly calibrated. The aluminium market is in turmoil—so much so that the Treasury, surprised by its own potency, may do a U-turn over Rusal. After ZTE, investors worry that Huawei, a Chinese rival, could be next. Its international sales are two-thirds as big as General Electric’s. Or take Chinese banks, which have built up huge dollar debts and deposits as they globalised. Last year the Treasury considered sanctioning CCB and Agricultural Bank, according to Bloomberg. In total they have $344bn of dollar liabilities; sanctions could start a run.
Killing me softly
The third conclusion is that other countries will develop ways to escape America’s reach. ZTE and Rusal offer a step-by-step guide to what you need to survive without American permission: semiconductors, a global currency and clearing system, credit-ratings agencies, commodity exchanges, a pool of domestic investors and shipping firms. These are all things that China is working on. America’s use of its new weapons simultaneously demonstrates its power and will hasten its relative decline.
Japan still has great influence on global financial markets
IT IS the summer of 1979 and Harry “Rabbit” Angstrom, the everyman-hero of John Updike’s series of novels, is running a car showroom in Brewer, Pennsylvania. There is a pervasive mood of decline. Local textile mills have closed. Gas prices are soaring. No one wants the traded-in, Detroit-made cars clogging the lot. Yet Rabbit is serene. His is a Toyota franchise. So his cars have the best mileage and lowest servicing costs. When you buy one, he tells his customers, you are turning your dollars into yen.
“Rabbit is Rich” evokes the time when America was first unnerved by the rise of a rival economic power. Japan had taken leadership from America in a succession of industries, including textiles, consumer electronics and steel. It was threatening to topple the car industry, too. Today Japan’s economic position is much reduced. It has lost its place as the world’s second-largest economy (and primary target of American trade hawks) to China. Yet in one regard, its sway still holds.
This week the board of the Bank of Japan (BoJ) voted to leave its monetary policy broadly unchanged. But leading up to its policy meeting, rumours that it might make a substantial change caused a few jitters in global bond markets. The anxiety was justified. A sudden change of tack by the BoJ would be felt far beyond Japan’s shores.
One reason is that Japan’s influence on global asset markets has kept growing as decades of the country’s surplus savings have piled up. Japan’s net foreign assets—what its residents own abroad minus what they owe to foreigners—have risen to around $3trn, or 60% of the country’s annual GDP (see top chart).
But it is also a consequence of very loose monetary policy. The BoJ has deployed an arsenal of special measures to battle Japan’s persistently low inflation. Its benchmark interest rate is negative (-0.1%). It is committed to purchasing ¥80trn ($715bn) of government bonds each year with the aim of keeping Japan’s ten-year bond yield around zero. And it is buying baskets of Japan’s leading stocks to the tune of ¥6trn a year.
Tokyo storm warning
These measures, once unorthodox but now familiar, have pushed Japan’s banks, insurance firms and ordinary savers into buying foreign stocks and bonds that offer better returns than they can get at home. Indeed, Japanese investors have loaded up on short-term foreign debt to enable them to buy even more. Holdings of foreign assets in Japan rose from 111% of GDP in 2010 to 185% in 2017 (see bottom chart). The impact of capital outflows is evident in currency markets. The yen is cheap. On The Economist’s Big Mac index, a gauge based on burger prices, it is the most undervalued of any major currency.
Investors from Japan have also kept a lid on bond yields in the rich world. They own almost a tenth of the sovereign bonds issued by France, for instance, and more than 15% of those issued by Australia and Sweden, according to analysts at J.P. Morgan. Japanese insurance companies own lots of corporate bonds in America, although this year the rising cost of hedging dollars has caused a switch into European corporate bonds. The value of Japan’s holdings of foreign equities has tripled since 2012. They now make up almost a fifth of its overseas assets.
What happens in Japan thus matters a great deal to an array of global asset prices. A meaningful shift in monetary policy would probably have a dramatic effect. It is not natural for Japan to be the cheapest place to buy a Big Mac, a latté or an iPad, says Kit Juckes of Société Générale. The yen would surge. A retreat from special measures by the BoJ would be a signal that the era of quantitative easing was truly ending. Broader market turbulence would be likely. Yet a corollary is that as long as the BoJ maintains its current policies—and it seems minded to do so for a while—it will continue to be a prop to global asset prices.
Rabbit’s sales patter seemed to have a similar foundation. Anyone sceptical of his mileage figures would be referred to the April issue of Consumer Reports. Yet one part of his spiel proved suspect. The dollar, which he thought was decaying in 1979, was actually about to revive. This recovery owed a lot to a big increase in interest rates by the Federal Reserve. It was also, in part, made in Japan. In 1980 Japan liberalised its capital account. Its investors began selling yen to buy dollars. The shopping spree for foreign assets that started then has yet to cease.
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