The fight for digital supremacy

China is at the forefront of a huge revolution in AI. Already, the United States realises it is no longer the leader.

Whenever Trump (left) is put in a corner, his tactic is to blame China! (President Xi right). The latest being his wish to distract from his Administration’s failure to contain the disease, Covid-19.

  Digital Standoff: The Fight for Tech Supremacy Between ...

https://youtu.be/0u9EMl3vv2M

Venture capitalists and experts Stella Ji Xin, Wei Jiang and Rebecca Fannin discuss what’s at stake as the standoff deepens, exploring the growing list of what could go wrong as a tech war looms.

CHINA bashing has become a bipartisan passion in the West, especially the United States.

Whenever Trump is put in a corner, his tactic is to blame China!

The latest being his wish to distract from his Administration’s failure to contain the disease, Covid-19 – such that America, despite having had months to prepare for it, now has the most Covid-19 cases and deaths in the world – far, far more than China.

Where recent pandemics – including the 2014 African Ebola outbreak – saw productive Sino-American co-operation, this one has taken the already poor relations between the United States and China to new lows. As I see it, they are likely to worsen, despite some efforts on both sides to rein in the rhetoric.

Chips war

Essentially, the conflict that matters most between the United States and China is the 21st century fight over technology– from AI (artificial intelligence) to 5G (network equipment). The real battleground is in chips or SCs (semiconductors) where US industrial leadership and China’s superpower ambitions directly clash.

Firms from the United States and their allies (including South Korea and Taiwan) dominate the most advanced areas of the industry.

China, by contrast, remains reliant on the outside world for supplies of high-end chips.

It spends more on semiconductor imports than it does on oil.

As far as I know, the list of top 12 SC firms by sales does not contain a single Chinese name. Well before Trump arrived on the scene, China made plain its intention to catch up.

Not surprisingly, China’s ambitions to create a cutting-edge industry worried Trump’s predecessor.

President Obama blocked and stymied the acquisition of chipmakers by the Chinese in 2015 and 2016. Other countries are alarmed, too.

Taiwan and South Korea have policies to stop sales of domestic chips firms and to dam flows of intellectual property. Since then, Trump has intensified the chips battle.

Three things have changed. First, the United States realised its edge in technology gives it power over China. Second, China’s incentives to become self-reliant in SCs attracted its tech giants to come on board: Alibaba, Baidu and Huawei, all ploughing money into making chips. And, China has showed that it can outcompete US firms.

China is destined to try to catch up; the United States is determined to stay ahead. Third, the SC supply chain is already too globalised for US to stop it.

Today, US has the edge over China in designing and making high-end chips. It can undoubtedly slow its rival.

But China’s progress will be hard to stop. Firms like Huawei have the proven ability to innovate; it spurred China on to develop its domestic supercomputing industry.

Zhongguancun

China’s own Silicon Valley – Zhongguancun – has come of age.

Originally a byword for cheap knockoffs in the electronics market, it has since evolved into a sweeping quadrant of north-western Beijing that includes its two leading universities, Peking and Tsinghua.

Zhongguancun is now a concept as much as a place for “self-dependent innovation of high-quality” economic development, to accelerate a shift from assembling tech products to creating them.

Surrounded by the world’s largest, fastest growing market for such goods, Zhongguancun is creating new apps, services and devices more speedily and cleverly than ever before.

Total venture-capital investment pouring into Chinese technology companies has grown rapidly, now reaching parity with the United States. New companies have ready access to capital and to refreshed flows of technically-minded graduates.

Indeed, China has long since moved beyond producing merely Chinese versions of Silicon Valley companies. The newest firms in Zhongguancun employ business models that do not exist yet in the United States.

Even in areas where Silicon Valley dominates globally (like social media), Zhongguancun can compete. But Zhongguancun’s real strength is in developing new applications and services in SCs and AI for the Chinese market, to be provided through smartphones.

Chinese digital services are often the first of their kind. The Chinese government has adopted a laissez-faire approach to such companies: “If there is no regulation, they let you run.”

To address one of Zhongguancun’s greatest weakness –a reliance on imported components and technology, firms are investing to make chips which manage charging devices wirelessly, or that fuse camera data into three-dimensional scans.

It is also investing in companies that design new materials – antibacteria ones for fabrics and mattresses, and ceramics for phones.

Zhongguancun is now set to blossom as a global, not just a regional, tech hub, to insulate China against protectionism.

The priority is to nurture its own suppliers. Chinese chip companies offer software for designing circuits, and handling licensing negotiations on behalf of its young tenants with other chip architecture firms.

The latest crop of start-ups has set their sights on foreign markets. They see the trade war not as a threat, but as an opportunity – to fill the gaps in Chinese supply chains and then compete in the West.

So far, very few Chinese tech companies have managed to go global, Huawei and Bytedance being the most prominent. And Huawei, in particular, is already under threat due to security fears in the West.

AI supremacy

China is at the forefront of a huge revolution in AI. Already, the United States realises it is no longer the leader. Today, fundamental AI innovation no longer matters, since the big intellectual breakthroughs have indeed occurred.

What matters most is effective implementation, not innovation. China has many advantages: (i) work of leading AI researchers is readily available online; (ii) its ceaseless “trial and error” approach is well suited to the effective rolling out of the fruits of AI; (iii) the dense urban settlements have created a huge demand for delivery and other services; (iv) its backwardness allowed businesses to leapfrog; (v) China has scale; (vi) there is a supportive government; and (vii) the Chinese is far more relaxed about privacy.

As I see it, China is fast catching-up in SC production. It’s already ahead in potential users, but has only about half the number of AI experts and companies.

What then are we to do

Not so long ago, all Top 10 technology companies were American.

Today, four among them are Chinese, including Huawei whose revenues amounted to less than US$28bil in 2009; they reached US$107bil in 2019. Telecoms and wireless technology are at the forefront of the competitive sparring between the United States and China.

In a world where everything is dual-use technology, it is difficult to distinguish what is commercial and civilian; what is strategic and military.

To have the technological edge is existential for both nations.

5G is a big deal, both in itself and because of its multiplier effect on a range of other technologies, including autonomous vehicles, the Internet of things, smart cities, virtual reality and, battlefields.

The first movers will set global standards. That in turn brings-in billions in revenues, substantial job creation and leadership in any other technologies that require ever swifter transmission of data.

The United States is determined that China will not dominate in 5G. The country that owns 5G will own many innovations and global standards.

As I see it, the United States will not dominate. Chinese equipment is cheaper and in many cases, superior.

No question US has lost its edge. Huawei today has become a national champion of China, mainly because of its huge investments – US$180bil over the past five years and has 10 times as many base stations as the United States.

Sanctions by US against Huawei is likely only to accelerate China’s efforts to achieve self-sufficiency.

To me, Western panic over Huawei is overblown. 5G will not yet profoundly alter consumers’ lives. True, it promises faster connections; but often only in optimal conditions. I know similar down-speeds can be achieved by extending 4G. Outside China, South Korea and a few other Asian countries, the uptake of 5G is likely to be slow.

Sure, 5G is more than just a faster way to stream. The extra processing oomph will allow base stations on networks’ “edge” to guide self-driving cars, or robots on factory floors.

5G will not just power telecoms but much of economic activity, making wireless networks into critical infrastructure.

Its wireless connectivity brings with it the next-generation Wi-Fi, constellations of low-orbit satellites and, soon 6G.

So, Chinese dominance of this wireless tapestry spooks many Western security hawks.

If Huawei is allowed to build even parts of these networks, it could wreak havoc in the event of a conflict between China and the West.

For all his China-bashing, Trump appears to have since demurred, instead heeding the concerns of America’s tech bosses, who warn that such a move can hurt their industry.

As I see it, the 5G race is not about out-innovating China but hobbling it. In the end, Trump faces a clear choice in doing something altogether very American: help usher in innovation that lets many companies thrive at a time when cheaper and better connectivity is precisely what a post-pandemic world really needs. But will he?

By Lin See Yan
The views expressed are the writer’s own.

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China battles US for AI and robotic space: Who’s ahead?

Robot dominates: Ford F150 trucks go through robots on the assembly line at the Ford Dearborn Truck Plant in Dearborn, Michigan. Robots are also entering areas such as logistics warehousing, chemicals and plastics factories and F&B industries. — AFP

Humans vs. Robots

NO doubt, the FAANGs – Facebook, Apple, Amazon, Netflix and Google – are making the world a better place.

Still, they are being accused of being BAADD – big, anti-competitive, addictive and destructive to democracy.

Regulators fine them, politicians take them to task, and even their backers warn of their power to cause harm. Much of the techlash is undeserved. There’s fake news everywhere.

Nevertheless, there is justified fear that the tech titans will use their power to protect and extend their dominance, often to the detriment of consumers. Indeed, the big tech platforms do raise worries about fair competition in particular.

In Singapore, the merger of Grab and Uber brings on legitimate concerns in the taxi space. The tricky task for regulators is how to restrain them without unduly stifling innovation.

Today, trust busters have granted tech giants the benefit of the doubt in the fight for artificial intelligence (AI) and robotic space. At some point, who takes the moral and legal responsibility for their mechanical creations?

Like it or not, AI-enabled bots and machines are already here, in the form of drones, driverless cars and medical, educational and domestic robots. To muddle the picture still further, AI is now embodied in physical, sometimes humanoid, form in machines designed to engage directly with people.

Talk is rife about the outright banning of killer robots, which cross the moral red line (only humans are permitted to kill humans!). Already, there is a proposal to create a Robotics Commission in US and Europe to be responsible for moral and legal issues surrounding the use of robotics and AI enabled smart machines. High time too.

Robots and cobots

Armies of robots and collaborative robots (cobots) are spreading throughout factories and warehouses around the world, as the accelerating pace of automation transforms a widening range of industries.

And it is not just in advanced countries but in emerging economies as well where machines are a growing force, with global sales of industrial robots increasing by 18% to a record US$13.1bil in 2016.

These groups are benefiting from mounting demand for sophisticated machines that no longer just weld car bodies and lift heavy loads, but also perform complex functions from electronic component production to arranging chocolates neatly into boxes.

Another trend is the increasing range and type of robot, as they vary from flexible mechanical limbs to smart machines that can work alongside humans. Cobots are specifically designed to interact with people.

The robotics market has been growing strongly and will continue to grow. The spread of robots has piqued the debate over the suitability of humans versus robots as workers, with warning that more machines will take jobs. Consultants McKinsey found that about 30% of tasks in 60% of occupations could be automated.

Advanced automation is partly a response to a shortage of skilled manual labour, with robots often filling “dull, dirty, dangerous and delicate” roles that people simply do not want. Also, the falling cost of robotics systems, and breakthroughs in robotics technology – combining with the rising level of electronic communication between equipment and computers in factories, sometimes called the industrial Internet of Things.

Then there is the shift in some industries from producing a small variety of goods in large batches, to a greater mix of products in smaller batches. All these are basically driven by consumers. Although the largest user remains the car industry (mainly for welding and painting), the main driver of growth is the electronics and electrical sector, chiefly located in Asia and mainly for batteries, chips and display.

But robots are also entering other areas, such as logistics warehouses, chemicals and plastics factories and the food and beverage industries. In total, almost 300,000 units were sold worldwide last year, with three-quarters bound for just five countries: China, South Korea, Japan, US and Germany. Three in every 10 went to China alone.

Once the manual labour “workshop of the world”, it has been the largest buyer of industrial robots since 2013, and its purchases jumped by 27% in 2017. There were increased investments in many developing countries as well, such as Taiwan, Thailand, India and Mexico, as well as in Italy and France.

While there have been improvements in hardware capabilities, such as hydraulics and mobility, perhaps the most important developments are in sensors and software that are making robots more sensitive, flexible, precise and autonomous. The software side of industrial robotics is becoming more and more important.

However, despite the growth, robots still have many limitations when it comes to dexterity, judgment and the ability to improvise. Today, machines are beginning to learn new tasks from humans by imitation. This has opened up big possibilities, especially for cobots, which are smaller, lighter, more flexible and mobile. And, even more critically cheaper, making it more affordable for small and medium-sized enterprises to invest. While usually slower, they have greater adaptability, because they can be assigned to different tasks.

US dominance

True, US roads, airports, seaports and schools are on the slide. But US retains dominance in the most sophisticated fields – defence, elite universities and technology. Sure, US ceded the top spot to China in exports in 2007, in manufacturing in 2011, and absolute GDP by 2030. But Silicon Valley is still where the best ideas, smartest money and the most savvy entrepreneurs reside.

But China is catching up fast: its BAT (Baidu, Alibaba and Tencent) are in the same league as the FAANGs and new stars are coming on fast (Didi Chuxing, Ant Financial and Lufax). China’s e-commerce sales are 2x US’ and China remits 11x more money by mobile phones than US (still scribbling cheques). China plans to lead globally in AI by 2030.

Its VC industry is booming – the entrepreneurial work-ethic in Beijing, Hangzhou and Shenzhen are a sight for sore eyes. Despite the huge progress, China remains far behind. Studies show that China’s tech industry is only about 42% as powerful as US (only 15% in 2012).

But Chinese tech has weak spots: (i) its total market value is only 32% of US; (ii) has two to three huge companies and lots of small ones; (iii) China is puny in semiconductors and business-facing software; (iv) its tech products has not as yet permeated the industrial economy; (v) Chinese non-techs are primitive – only 2.6% as digitalised as US; (vi) Chinese tech investment budget is only 30% as big as US, with foreign sales 18% of what US makes.

However, the gap narrows in the more dynamic parts of tech industry: (a) in e-commerce and internet, Chinese firms are 53% the size of US (in market value); (b) China’s unicorns are now worth 69% of US; (c) its VC activity, 85% of US in 2016; and (d) in “breakthrough” AI innovations, China’s population of AI experts is only 6% the size of US – with their best minds still working in large US techs; while cited AI papers by Chinese scientists are at 89% of US.

At the present pace, China will need a further 10-15 years to catch up. Viewed from China, US giant techs remain as “comfy monopolists”, while Chinese techs are plain “hungry”. Beijing’s blueprint: to create a US$150bil AI-industry by 2030 underlines its desire to beat US.

China’s advantage: sheer numbers of people, data, talent and superior lines of codes being written! At 730 million, China’s online population alone is more than 2x US size, and more tech-savvy. While US faces cut-backs in research money, China is committing ample money and also political capital into its relentless drive to reign supreme in AI.

However, the quality of fundamental research in China remains a problem. It lags behind EU in terms of the number of AI papers in the top 5% of most cited.

Where’s EU?

Few in US and China seriously regard Europe becoming a force in machine learning – the area AI has made the most progress in recent years. The process involves feeding reams of data through algorithms as AI learns to interpret other data.

Europe simply lacks scale; unlike US and China where tech giants have a surfeit of the most vital resource for AI – data; also attracted the best talent & boost the biggest computer clouds. Here, Europe is way behind.

Since US and China have centralised data systems (controlled by very few large firms), Europe can create a more decentralised option. China is expected to hold 30% of world data by 2030; US with just as much. Europe has data too, but needs to pool its diversified resources in research and data. But, Europe has institutional inertia, with much of its funding centered in academic institutions – not the best place for it. To be relevant, Europe has to do much more. Still, no match for US and China.

Silicon Valley: where next?

The stretch of land in the US Bay Area running from San Jose to San Francisco is home to three (Apple, Facebook, Google) of the world’s five most valuable tech giants. All claim Silicon Valley (SV) as their birthplace and home, as do trailblazers such as Airbnb, Tesla and Uber.

The Bay Area has the 19th largest economy in the world, ranking above Switzerland and Saudi Arabia. SV has become a byword for innovation and ingenuity. It has also been at the centre of several cycles of Schumpeterian destruction and regeneration, in silicon chips, personal computers, software and internet services. Its combination of engineering expertise, thriving business networks, deep pools of capital, strong universities and a risk-taking culture have made SV almost impossible to clone.

There is no credible rival for its position as the world’s pre-eminent innovation hub. But there are signs that SV’s influence is peaking. Yes, something is changing. According to a recent survey, 46% of residents surveyed plans to leave the Bay Area in the next few years, up from 34% in 2016. So, many startups are branching out: “Off Silicon Valleying.”

In 2013, SV investors put half their money into startups outside the Bay Area; now it is closer to two-thirds. Reasons: SV has just become too expensive; among the world’s costliest. Young startups pay at least 4x more to operate here. New technologies, from quantum computing to synthetic biology, make lower margins than internet services. There is also the nastier features of Bay-Area life: clogged traffic, discarded syringes and shocking inequality. The Miami-Fort Lauderdale area is now ranked first for startup activity, based on the density of startups and new entrepreneurs.

There are others: Los Angeles (which has a vibrant tech scene), Phoenix and Pittsburgh (have become hubs for autonomous vehicles); New York (for media startups); London (for fintech); Shenzhen (for hardware). None of these places can match the SV on its own; between them, they point to a world in which innovation can be better distributed. The problem is that the wider playing field for innovation is being levelled down, away from the dominant effects of tech giants.

Second, the increasingly unfriendly policies in the West. Rising anti-immigrant sentiment and tighter visa regimes have economy-wide effects: foreign entrepreneurs create around 25% of new companies in America. Unfortunately, SV’s peak looks more like a warning that innovation everywhere is becoming harder. SV is fast becoming more an idea instead of a place. Wall Street went through a similar transformation; its name becoming shorthand for a whole industry.

As tech firms set their sights on disrupting old-fashioned industries, like healthcare and logistics, they may find that it helps to be based in cities that claim deep expertise in these areas – and where garages housing startups are just the stuff of museums and memory.

What then are we to do

The time has come to love robots. Asians do. But not in the West where robots receive terrible press. They worry about robots killing jobs. In Asia, robots are today commonly used in Japan, South Korea, Taiwan and China. ADB’s June 2018 report analysing 12 developing Asian economies in 2005-15 concluded that rising demand had more than compensated for jobs lost to automation. The adoption of new technologies, such as modern machine tools and computer systems in factories and offices, had stimulated higher productivity and economic growth. That transformation, it estimated, had created 124 million new jobs, compared with the 101 million jobs lost to technology.

It is worth noting that there are two types of robots: those that do the work of humans and those that enhance their performance. We hear too much about the first type and too little of the second. Sure, their creations help humans deal with the “3 Ds”: dirty, dull and dangerous tasks. But countries that have the highest adoption of robots also have the lowest unemployment rates. Also, they help address the acute demographic squeeze as societies rapidly age. Some Asian societies prefer robots to immigrants to supplement their shrinking workforces. Robots are increasingly moving out of the factory into homes and hospitals, where they will need new capabilities.

I believe that technologies are always a net job creator over the long run, but, as Keynes put it, in the long run we are all dead. As these technologies make their way into every industry, they will benefit those at the very top with the skills and education to leverage the productivity advantages that AI affords.

Medical specialists, for example, could dramatically increase their income by using AI’s productive analytics to better diagnose and treat patients. But workers doing highly repetitive tasks that can easily be done by machines will not fare so well. This has massive consequences.

A McKinsey report shows that, while digitalisation has the potential to boost productivity and growth, it may also hold back demand if it compresses labour’s share of income and increases inequality. We badly need a kind of digital New Deal. For as many jobs as will be replaced by automation, there are other areas – customer service, big data analysis, etc. – that desperately need talent. Companies that pledge to retain workers and retrain them to develop skills to get stable jobs, should be offered tax incentives to do so. And spend the cash on factory upgrades, technical improvements, and re-training costs.

There are plenty of such projects that workers could be deployed now – including helping to expand rural broadband. It is a way for companies and government to turn a potential difficult employment situation into an opportunity by using this disruption to prepare & train a 21st-century digital workforce, and build public infrastructure to support it.

Credit: What are we to do? by Lin See-yan - Former banker, Harvard educated economist and British Chartered Scientist, Tan Sri Lin See-Yan is the author of The Global Economy in Turbulent Times (Wiley, 2015) & Turbulence in Trying Times (Pearson, 2017).

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Bizarre world of new debt, low, even negative interest rates a threat to global stability

New debt crisis a threat to global stability

 

https://en.wikipedia.org/wiki/Debt-to-GDP_ratio; 

The global debt clock: http://www.economist.com/content/global_debt_clock

Global debt has jumped alarmingly to RM631tril and as capital flows out from developing countries, some are facing new debt crises.

DEBT worldwide has grown to unprecedentedly high levels and has to be brought down to prevent another financial crisis.

This was highlighted by the Inter­national Monetary Fund at its annual meeting in Washington last week.

Other problems facing the global economy include the stagnation in world trade, a decline in commodity prices and the reversal of capital flows to developing countries.

A recently released United Nations report has analysed the situation as a third phase in the global crisis that began with the United States in 2008, then spread in a second wave to Europe, and is now moving on to the developing countries.

The IMF said that world debt had reached US$152tril (RM631tril), a record level. It was 200% of the value of global gross domestic product in 2002, but has risen to 225% in 2015. The private sector holds two thirds of the total, but government debt has also risen fast, and the IMF warned about the risk of another financial crisis.

“Excessive private debt is a major headwind against global recovery and a risk to financial stability,” said Vitor Gaspar, IMF director of fiscal affairs. “Rapid increases in private debt often end up in financial crises.”

Most of this global debt is concentrated in developed countries. The huge jump there has been due to policies of easy money and low, zero or even negative interest rates, and especially to quantitative easing in which Central Banks bought bonds and pumped trillions of dollars into the banking system.

 

https://sputniknews.com/europe/201607121042814891-germany-italy-europe-financial-crisis/

It was hoped that this massive infusion would cause the banks to increase lending to consumers and businesses and thus stimulate economic growth.

However, the real economy did not benefit much. Instead, most of the money went into the equity markets, boosting prices, and to the developing economies as investors searched for higher yield, and this helped to fuel the growth of their debt.

The debt of non-financial corporations in emerging economies jumped from US$9tril (RM37tril) at end-2008 to over US$25tril (RM104tril) by end-2015, or from 57% to 104% of their GDP.

Foreigners now own unprecedentedly high shares of bonds and equities in developing countries, which have become vulnerable to investor-mood swings and funds, resulting in financial crises.

When market sentiment or conditions change, the massive inflows can turn into equally large outflows. Indeed, the boom-bust cycle of capital flows has gone through many turns through the years.

Huge amounts left developing countries in the fourth quarter of 2015, and for that year as a whole there was a net outflow of US$656bil (RM2.7tril) or 2.7% of their Gross Domestic Product, according to the UN Conference on Trade and Development (UNCTAD).

This was a big change from a net inflow of 1.3% of GDP in 2013. This turnaround of 4.4% is much larger than the reversals of capital flows in 1981-83, 1996-98 and 2007-08.

But in recent months the cycle turned again, with the return of fund investors to emerging economies. For example, in Malaysia, after suffering large outflows in 2015, there have been net inflows of funds into the equity and bond markets in the past few months.

Going through these cycles, the debt of developing countries has grown. “Easy access to cheap credit in boom times has led to growing debt levels across the developing world,” says UNCTAD’s Trade and Development Report 2016.

Developing countries’ external debt rose from US$2.1tril (RM9tril) in 2000 to US$6.8tril (RM28tril) in 2015. Overall debt (foreign and domestic) jumped by over US$31tril (RM129tril) with total debt-to-GDP ratios reaching over 120% in many countries and over 200% in some others.

Now a nightmare scenario is emerging. For many countries, the tide is turning and access to cheap credit has begun to dry up. Says UNCTAD: “Against the backdrop of falling commodity prices and weakening growth in developed economies, borrowing costs have been driven up very quickly, turning what seemed reasonable debt burdens under favourable conditions into largely unsustainable debt.”

In some countries, the problem is compounded by currency devaluation (which increases the value of external debt) and lower commodity prices.

These countries are thus hit by multiple whammies – lower commodity prices and export earnings, net outflow of funds, devaluation (which causes their foreign debt to increase), a higher cost of servicing debt, and economic slowdown.

More and more low-income countries are in a downward economic spiral that has led them into a new debt crisis. They have had to turn to institutions like the IMF and World Bank for bailouts. UNCTAD lists Angola, Azerbaijan, Ghana, Kenya, Mozambique, Nigeria, Zam­bia and Zimbabwe as countries that have already asked for financial assistance or are in talks to do so.

This points to a shortfall in the international financial system – the lack of an orderly and fair debt mechanism which countries facing a debt crisis can have recourse to.

At the national level, the developed countries and some developing countries have corporate bankruptcy laws, aimed at helping companies to recover from a debt crisis through an orderly debt workout.

But there is no such debt workout mechanism, with fair burden sharing between debtor and creditors, when countries fall into a debt crisis.

In its absence, indebted countries often face many years of austerity and recessionary conditions im­­posed by the creditors and rescuing agencies, and with no guarantee that their debt level will even decrease.

With the present level of worldwide debt and the emergence of a new debt crisis in several countries, especially poor ones, it is time to consider smarter policies that prevent debt crises, and to manage them properly when they happen.

Global Trends By Martin Khor Global Trend The Star/ANN

Martin Khor (director@southcentre.org) is executive director of the South Centre. The views expressed here are entirely his own.

The bizarre world of low, even negative, interest rates

 

Draghi’s point: ECB president Mario Draghi speaks during a news conference in Berlin. He vigorously defended his stimulus policies to critical lawmakers in Berlin, while reaffirming the urgency to step up structural reforms. – Bloomberg

INTEREST rate is the price of money.

It sets the benchmark as it serves to oil the financial system’s engine, helping capital to flow freely and effectively in the global economy. Rates have been positive for the past three centuries despite world wars and the Great Depression. The system is not designed for a world of ultra-low, let alone negative rates.

The traditional business of banking, as we know it, is to take money from savers (in the form of deposits – representing banks’ liabilities) and lend it, at higher rates and over longer periods, to borrowers (investors, whose loans become their assets). Essentially, banks borrow short and lend long.

So the shape of the yield curve (chart of interest rates reflecting their term structure) is critical as it drives profits. The smaller the margin (gap) between short and long-term rates (i.e. the flatter the yield curve in economists’ jargon), the tighter banks’ profits are squeezed. The problem becomes even more difficult as interest rates or bond yields move near or to zero or worse, get negative.

Negative world

Negative rates invert the norms of banking. Strangely, borrowers are paid for taking money, while savers pay to hand over their deposits. Banks already face resistance from depositors who won’t pay to save with them. Even as the return on their assets falls, banks find it hard to reduce the cost of their liabilities. When central banks impose rates on the reserves kept by banks with them – as is done at the European Central Bank (ECB) and Bank of Japan (BoJ) – it’s difficult for the banks to pass on this cost.

Indeed, negative rates act as a tax on bank profits. Banks also own government bonds, partly because regulators require them to keep a portfolio of liquid assets. Revenue here is a handy source of income. But as the older, high-yielding bonds mature, their replacements are now much lower yielding, thus eating into banks’ profits.

So banks look for other ways to re-coup, resorting to fees for services. Indeed, wealthy clients of private banking are starting to wake up to the impact of fees.

Insurance companies are also badly affected. They buy bonds to match assets with their long liabilities. But insurance companies in Germany and Switzerland are stuck with savings products they had sold in happier times, which guarantee returns well above current yields. A similar problem hit Japan in the 1990s and 2000s. Those with asset management arms have some protection, where returns are linked to the markets. But the impact of low returns is slowly but surely squeezing them too.

Impact

The underlying economic problem today remains inadequate global demand. In response, ECB has since stepped up its stimulus activities, joining BoJ and others in breaching the “zero lower bound” (inability of interest rates to get negative). So far, the impact on growth and employment has been dismal – simply because there is so much excess capacity worldwide.

Lower rates (even going negative) don’t appear to work. Lending has become more risky and banks today, as I see it, have neither the appetite nor enthusiasm to lend. Negative interest rates (NIRs) hurt banks’ balance sheets.

Other problems: NIRs (i) encourage investment in capital-intensive and disruptive technologies; (ii) perversely encourage savings – as fixed, interest-dependent income earners dampen consumption; (iii) curb a bank’s ability to lend; (iv) distort financial markets; and (v) shift portfolios to riskier assets in search of higher yields. In the longer run, NIRs compel businesses and individuals to disengage from a financial system that now taxes their saving.

Short-term rate and government bond yields represent the risk-free rate that forms the basis of return in finance. The expected return on equities comprises this risk-free rate plus a premium to allow for stock volatility and risk of capital loss. A good chunk of income of service providers is the “cut” they take. Today, there is simply much less return to go around.

Global trading in government bonds had exceeded US$10 trillion, a testament to just how hard central bankers are pushing yields down to spur households and businesses to spend. US 10-year Treasury now yields below 1.7%. Returns on comparable bonds in Germany and Japan are negative. Falling rates promise limited relief for consumers and businesses because inflation is falling too. For many in Europe and Japan, even record low rates don’t translate into easier borrowing terms on a real, or inflation adjusted, basis. For example, 10-year Japanese bonds return a -0.07%; but consumer prices fell 0.3%, yielding a +0.23% at 10 years, a key rate for most Japanese. NIRs don’t appear to have helped boost inflation in Europe either. The real case against NIRs is the folly of relying on monetary policy alone to rescue economies from depressed conditions.

Scandinavian experience

Among Scandinavian nations, Denmark already has four years of NIRs. Its central bank benchmark rate now stands at -0.65% (mortgage rate, excluding fees, being at negative 0.0562%). Neighbour Sweden’s is -0.5% (below zero for 14 months). In Norway, rates can go negative to prop-up an economy hard hit by low oil prices. ECB and BoJ are using sub-zero rates to stimulate growth with little success.

Meanwhile, Switzerland, Sweden and Denmark are trying NIRs to keep their currencies in line with the struggling euro. Their experience points to concerns about undesirable side-effects, including: (i) savers pay the price of getting no interest; even so, bank profitability is squeezed; (ii) excessive investment in real estate; (iii) households gorging up mortgages they can’t afford to repay when rates rise or real estate values fall.

Sweden’s household debt to disposable income ratio is at an unsustainable 175% (90% in mid-1990s); and (iv) run to physical cash by savers. The flip-side points to success in keeping the currency in check, holding steady against the euro to protect euro-trade and competitiveness.

In Denmark, despite NIRs, private saving is rising (26% of GDP, against 21% before 2012 when rates were positive) to protect future purchasing power. But, investments fell (16% of GDP against 18.1% in 1990-2012). So, NIRs appear to be counterproductive. This chorus of discontent is spreading to other parts of Europe.

NIRs have pushed up savings and done little for corporate investment, while eviscerating pension plans. Politically, in Europe’s sclerotic economy, in the face of high unemployment (double the US rate) and an uncertain outlook, NIRs can be even more toxic, driving voters to support populist causes.

Japan

BoJ took radical measures for 3½ years to reflate the country’s sagging economy, resorting this January to NIRs. Yet growth and inflation remain elusive. Core-inflation is at minus 0.5%, far below BoJ’s 2% target. Prices today are still lower than they were in 1997. BoJ’s primary method to raise consumer expectations has been buying assets, mostly government bonds but also real estate and equities.

As a result, Japan’s monetary base tripled to US$4 trillion (80% of GDP). Investors’ patience is fraying. In a bold move to deepen the yield curve, BoJ on Sept 21: (i) capped the 10-year government bond rate at 0%, vowing to overshoot its 2% inflation target; and (ii) maintained its existing policy to purchase 80 trillion yen (US$78bil) of assets a year. Both these goals are incompatible. They pose a dilemma – in the event demand for government bonds collapses, BoJ will need to buy more and more to keep yields at zero. Similarly, strong demand may even make it unnecessary to buy any.

As I see it, the new approach is a sensible response to market realities. BoJ had conceded real difficulties in shifting price expectations towards the inflation target. Besides, the flattening yield curve is eating into banks’ profits.

By targeting its future purchases at the shorter-end (rather than buy longer bonds as now), BoJ is expected to tolerate a steeper yield curve. The yield cap should make NIRs more effective. Indeed, it allows BoJ to further test the bounds of its NIRs policy. In essence, the new approach shifts focus to interest rates, a retreat from the unpopular quantitative easing (QE). For investors, there is no longer a willing buyer. Instead, a price setter – adding uncertainty. Its pledge to overshoot the inflation target as soon as possible is designed to raise future price expectations more forcefully.

Whether BoJ can shake off deflation depends on whether domestic demand can revive to rekindle the still elusive price expectations. QE needs to be accompanied by more purposeful fiscal stimulus – including even a last ditch effort to issue “helicopter money” – to directly underwrite government spending by BoJ.

In search of yields

With NIRs, some of the world’s un-venturesome investors – the Japanese – are going abroad at an unprecedented rate this year: up to US$500bil being invested so far in foreign securities. For the risk taker, Venezuela bonds earned as much as 27% return over the past year. However, most prefer to just take “duration” risk: measured on when the investor gets his money back.

Longer bonds have higher duration risk – as do bonds with low coupons (more waiting time). Rule of thumb: 1 percentage point change in the rate changes the bond price equal to the duration. The price of 25-year bonds will jump 25% if rates fell by 1 percentage point; and falls 25% if rates rose 1 percentage point. As duration gets longer, risk mounts. For example: last year, 40-year Japanese bonds carried a 1.4% coupon. Rates have since turned negative; so the price rose by as much as 34%.

What then, are we to do

It is startling that the total volume of sovereign and corporate bonds with NIRs now exceeds one-half of all western debt. It’s equally amazing how investors continue to gobble up these bonds even though they are likely to get back less than what was invested.

Just as astonishing is the rising demand for cash – the world’s largest asset managers now hold 5.8% of their assets in cash! Why? Points to investors and fund managers being downbeat on the ability of central bankers to raise inflation in the face of growing pessimism about growth prospects (17% of them expect a global recession, and as many as 39% expect “helicopter money” to be handed out). Most fear the policy landscape will become weirder.

QE appears broken. This playbook has limited success in US and is patchy at best in Europe and Japan. Frankly, US bankers and economists are growing increasingly uncomfortable with the cycle of QE infinity and more aware of its collateral effects, including keeping US dollar cheap.

But consumers and businesses have been saving rather than spending, with stagnant unemployment overshadowing the windfall from rising asset prices. European banks have been hit by low interest rates, tighter regulation and rising non-performing loans that have hurt profitability. Policymakers are today rethinking strategies. Mario Draghi is, and Haruhiko Kuroda has had a recent relook. The key question remains: how to regain policy effectiveness. That’s where the focus should be – adopt pro-growth structural reforms to make the economies more competitive, and to enhance fiscal creditability.

Sure, BoJ has to make people believe in inflation. Inflationary expectations won’t materialise until BoJ is credible. Credibility – that’s what makes our world in 2016. In the US, both presidential candidates have pledged fiscal stimulus. Hopefully, by next year (after elections in Spain, Germany and France), a more balanced application of softer QE and aggressive fiscal stimulus can turn Europe from a good trade into a good investment.

• What are we to do?

  By Lin See Yan

Former banker, Harvard educated economist and British Chartered Scientist, Tan Sri Lin See-Yan is the author of The Global Economy in Turbulent Times (Wiley, 2015). Feedback is most welcome; email: starbiz@thestar.com.my.


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