A Top CRO Weighs the Risks of Asia Against the Risks of the U.S.A.
I have a good friend who is Chief Risk Officer at a “globally systemic” financial institution (which is regulator-speak for “darn big and important”). And, gosh, does my friend not want his name in print. “It would be risky,” the Chief Risk Officer explains. However, he did agree to talk to me off-the-record. I’ll call him “Chief Risk Officer X.”
Before Chief Risk Officer X assumed his current duties, he was a banker in New York for a large, international investment bank with a substantial presence in the Far East. His work included early forays into “newly open-door” China.
My friend knows Asia. He knows risk. And he knows when the two are synonymous… and when they aren’t.
P.J. O’Rourke: You know me, I’m a foggy old Liberal Arts major. So I hope I’m getting this right. As I understand it, the Chief Risk Officer, or “CRO,” makes sure a company is compliant with government regulations, and reviews factors that could negatively affect the company’s business and investments. The CRO is the executive responsible for identifying, analyzing, and mitigating events that could threaten his or her company. Is that correct, more or less?
Chief Risk OfficerX: More or less. The CRO’s function is to understand the wide array of potential outcomes that could result from the risks that the company takes in its businesses and the way those risks interplay with global markets and economies. Furthermore, the CRO has to ensure that all the stakeholders’ interests are correctly considered in balancing risks with capacity to absorb losses.
P.J.: I don’t know if I’ve ever told you this, but I think of your job as the “Job of Jobs.” I mean, isn’t “identifying, analyzing, and mitigating risks” what responsible adults, decent parents, and good citizens do all day? For instance, when we say things like… “Maybe you should let someone else drive,” or “Stop sticking things up your nose!” or “Don’t vote for that idiot, vote for the other idiot.” Seems like we all are – or ought to be – Risk Officers.
CROX: Certainly we all have a core responsibility to balance risks with opportunities as we move through life. The more successful move through life elegantly and the less successful either push too hard – in your vernacular, “put things up their nose” – or are paralyzed by the fear of anything bad happening to them. Think of catatonic types who own many, many cats. My job is to ensure that the interests of the “Cat Crowd” – nervous shareholders, customers, counterparties, rating agencies, and regulators – are appropriately represented in optimal outcomes for the firm.
P.J.: Let’s say you’ve just become “Chief Risk Officer of the World.” And, as World CRO, you’re looking at the economies of the U.S. and China…
CROX: The current understanding of the preponderance of experts seems to be that the U.S. is in a much stronger position than China to continue to grow and prosper – and to meet future challenges as we move towards new technologies, a digital economy, and a world without work.
The growth and levels of respective debt and the aging and shrinking of respective populations are the two main pillars for this position. On the surface, these arguments are compelling – and certainly problematic for China. But on a relative basis one can argue that the U.S. is every bit as challenged, if not more.
Political instability is a constant worry, and green shoots of growth can quickly revert to destitution and poverty.
China’s total debt levels, while profound at over 300% of GDP, are materially lower in comparison when U.S. debts are fully aggregated to include mortgage debt, retail debt, corporate debt, government-funded debt (including state and municipal), and unfunded obligations at the state, local, and national level.
To give you an idea of the size of this problem, in the financial statement that the Congressional Budget Office releases each February, the present burden of U.S. government future obligations (offset by anticipated future revenues) was estimated to be $46 trillion at the end of 2016. (The most recent figures we have.)
This is $46 trillion in obligations after the subtraction of $15 trillion in payments expected from future participants in the social security system – many of whom haven’t been born yet. And many of the rest are not currently employed and maybe never will be.
Add that $46 trillion to the government-funded and direct debt of approximately $20 trillion, then add state- and municipal-funded and unfunded debt and we are substantially in excess of 300% of GDP. And we haven’t even mentioned private-sector debt, which adds another 200%. Additionally, over the past 30 years politicians have managed to sell or do sale-leasebacks on just about every government asset, leaving the government’s asset-portfolio cupboard bare.
Of course, it’s not all bad news. Aggregate net worth of Americans is in excess of 500% of GDP, leaving us with adequate wealth to repay this debt over time. However, the individual citizens who own these assets think of them as theirs, not the government’s. Transferring private assets to public coffers might be… problematic and noisy.
The reason the U.S. economy continues to grow despite this enormous debt burden is that the U.S. dollar still reigns as the world’s reserve currency. And the U.S. economy continues to drive a large share of global wealth, creating dollar net worth worldwide.
Democracy makes it certain that hard decisions and difficult choices are deferred or made slowly or partially.
As for China… Historically, the Chinese economy was not a driver of global wealth. But with the transformation of that economy over the last 35 years, China has become the second-largest contributor to global wealth creation… and the fastest growing both in percentage and nominal currency terms.
True, much of China’s growth can be tied back directly to debt creation… but still, the world is paying attention. The strategy seems to be working. And, even with all of its growth, China’s per capita GDP is less than one-seventh of America’s, leaving China with substantial room for growth as domestic demand creates additional wealth, and as the globalization of the economy leads to increased alignment of standards of living.
Finally, the Chinese government still owns substantial assets – both real and corporate. These are available to be transferred (in a way that’s not “problematic and noisy”) should circumstances require.
Because so much of China’s net worth remains in government hands, it is available to meet future needs. And, although demographics are working against the Chinese economy, the Chinese government still has a system where the aged and infirm are largely the responsibility of their children, and not wards of the state – thus the slower pace of China’s creation of unfunded long-term liabilities.
P.J.: Let’s delve a little deeper into China’s demographics. A recent article in Forbes claimed that the population in China may be aging faster than anywhere else on earth – even faster than at my house where the kids are leaving for college and I’m getting older by the minute.
CROX: Aging and declining population is a much more nuanced issue. (Not at your house. You are getting old.) But the path and the metrics to quantify demographic trends are much harder to discern than they are for purely economic trends. Yes, we can point to the pace of Chinese population decline and to the seemingly inevitable implications of shrinking population on GDP. However, this fails to recognize the complexity of China’s emergence as a regional and global economic power.
China is thriving in a region with the fastest growing populations in the world – Malaysia and Indonesia, for example. The region also has emerging political stability, creating platforms for economic growth.
Viewed demographically, the region’s population remains stable over time, with China providing an engine to drive growth and promote stability in regional partners.
P.J.: Another possible problem is China still being heavily import-dependent for its energy and manufacturing needs. Does this make China the “Jimmy Carter” of Asia?
CROX: No. Besides regional population growth offsetting China’s demographics, there are emerging – though still tenuous – alliances with resource-rich African countries. The prospects for the creation of growth in Africa might be a solution for Chinese resource needs. Imagine the creation of a pan-Asian economic region led by China, with strong investments in sub-Saharan Africa.
Admittedly there are many places where this strategy and vision can break down. Political instability is a constant worry, and green shoots of growth can quickly revert to destitution and poverty. But given the benefits of these alliances, combined with China’s consumer demand, capital, and capabilities, it is not unreasonable to assume that these alliances will reduce – if not eliminate – the linkage between shrinking population and resource dependency and Chinese economic growth.
And there’s another aspect to the energy question. The Chinese are also very focused on creating a greener environment. Partly, this is due to significant objections to the current state of air quality in Beijing and Shanghai. But there’s a strong “renewable-sustainable” aspect to the program. And the Chinese government has the ability to effect and enforce its program quickly.
P.J.: And yet another problem… rule of law and property rights. The U.S. has transparent rule of law and property rights. Rule of law and property rights in China are, to be polite, opaque.
CROX: The rule of law question is interesting. In the U.S. we have well-defined property rights. But… Think about the implications of our aggregate debt. You will see an inevitable transformation over the very long term. So, while Chinese property rights and rule of law are – to be kind – “developing,” our property rights are likely to be superseded by the realities of wealth transfer promises made over the last 40 years.
P.J.: Not to be “Debbie Downer” here, but in December, Deutsche Bank analysts released a report estimating that China is twice as likely as other major economies to experience a financial crisis in the relatively near future. The analysts pointed to Chinese businesses’ notoriously high debt levels.
CROX: I cannot imagine how Deutsche derived the prediction that China is twice as likely as other economies to have a crisis – other than by doing some sort of simple volatility analysis or through some kind of “mean reversion” thought process – like, “what goes up must come down.”
It is likely that in the short term, the Chinese path is bumpy. There will be plenty of stakeholders overreacting as data points are unveiled. The way forward is complex, with political and economic challenges. But while China’s government is saddled with having to do a lot to keep its citizens on board with the economic transformation and not in revolt, the government is doing it with a lot of very smart folks who are thinking about long-term objectives and solutions.
The Chinese are not subject to a political system that consistently elects charlatans, frauds, and people-pleasers maneuvering through choppy waters while trying to be re-elected from the day they reach office. The Chinese are not subject to a political system that necessarily focuses only on the short term.
P.J.: An excellent vest-pocket description of our political system. And yet, in the long term, democracies have produced the best economic results. Speaking of which, Japan has a political system similar to our own. And Japan did very well for a long time. Any chance of a second wind for the Japanese economy?
CROX: That’s increasingly a real possibility, although the population issue is very much in play there, as well as debt levels. However, the power of the remarkable spending by developed countries over the last decade, combined with the inevitable reversal of inertia, is creating real economic growth in virtually all corners of the globe. Even with its challenges, Japan continues to have a highly educated workforce and substantial sources of capital.
Economies with those advantages – even if they have epic levels of debt – are likely to do well… perhaps even very well.
P.J.: Why hasn’t India’s economic growth kept pace with China’s? India would seem to have many advantages – high rates of literacy in English, civil liberties, reasonably good rule of law and property rights, long-standing trade ties to the West…
CROX: While economic growth and systemic transformations in India have been very positive over the last decades, it’s true that India hasn’t kept pace with China. Why? This may seem revolutionary to say but, in a word, democracy.
Democracy makes it certain that hard decisions and difficult choices are deferred or made slowly or partially. This versus the more authoritarian Chinese way of doing things. Democracy will continue to muddy the path forward for India.
My comments about democracy are not just aimed at India. However, the problem with dictatorships is that they come in two forms. There’s the good kind – benevolent, with due process and legal infrastructure. And there’s the bad kind – mercurial despots acting like absolute monarchs with authority unlimited by law, legislation, popular will, or traditional customs. The problem being that the good kind can change into the bad kind without warning.
P.J.: Still, what you say about democracy is not good news.
CROX: You didn’t ask me for good news.
P.J.: As you survey Asia’s economic scene, are there any places that you would tell investors and business people to “stay the hell away from”? Are there some mangy dogs among the tigers?
CROX: While each of the tigers in Southeast Asia has relative strengths and weaknesses and differing levels of risk, if the pan-Asian notion continues to gain ground it is hard to find a truly mangy mutt. Of course, this could all turn on its ear if prospects for political stability start to look cloudy.
P.J.: Lastly, since you’re the world’s Chief Risk Officer, I feel obliged to ask you, “North Korea, WTF?” Should the world fight? Or flee? Or shelter in place?
CROX: I suspect the answer is to relax. Partially because if you live in Seoul, fleeing isn’t terribly useful. (Maybe it isn’t useful if you live in Hawaii, either.) And partially because the North Koreans are unlikely to start an affair that could end with a substantial part of their population being eradicated. My hope is that they are whack jobs – but not suicidal!