Thought Arena Beta

 

There were many who thought that the vote could go against staying in the EU; many fewer thought that the vote would go that way; virtually none in power – politically or commercially – believed that it could or would.  As such, on both sides of the Channel, virtually no deep thinking, strategizing or planning actually took place ahead of time.  The financial markets reacted as they should have, pricing in a large amount of negative uncertainty into the Pound, the Euro and many securities in both markets.  After the requisite few days, the volatility subsided; this, however, did not in any way signify the storm has passed.  There always are a sufficient number of risk takers who are willing to buy on dips, thereby preserving a short-term manageable range in prices.  Over time, the Euro has ostensibly stabilized, while the pound has continued its free-fall, stabilizing only during October.  If/when news occurs and developments actually take place, the room for extreme downside movement remains alive and well for both currencies.

And, although with Theresa ‘s announcement, the vast majority of commercial interests and now, a large number of politicos believe a separation to be inevitable, most believe it is neither in the general interest of the EU nor Britain.  The only hope is that, rhetoric aside, the shambolic process seen to date on both sides of the Channel will morph into something vaguely rational.  However, with the current cast of characters, it is hard to be unduly optimistic.

The result of Brexit has been an upheaval of the British political scene, with David Cameron resigning and an unexpected candidate quickly stepping in.  Gove was responsible for knocking out two of the most obvious candidates, Boris Johnson (the U.K.’s Trump imitator) and himself in one of the clumsiest pieces of political argy bargy in recent history, leaving the pathway open for Theresa May.  The Labor Party, showing itself more indecisive than even its most vociferous critics had believed possible in the Brexit debate, has left itself essentially emasculated.  The rift between the Party faithful and those actually elected to office highlight the chaos.  Thus, one of the most critical periods in British political history will be undertaken with a great uncertainty at the top; hopefully new blood will represent the infusion of sanity the UK desperately needs, but the ‘surprising’ ministerial selection and the early May positioning do not inspire great confidence.

Across the Channel, the rhetoric has just begun – with years more certain to follow; Juncker and the French have led the bloviating with aggressive posturing against making any concessions to the British.   Merkel has stood behind her basic premise that you can’t leave the Union and expect a pat on the back and sympathetic wooing.  The fundamental leadership vacuum in Europe (excepting Merkel) has left only the nationalist parties cooing and rubbing their hands, as they expect major gains in elections throughout Europe over the foreseeable future.  Using immigration as their basis of discontent, the increase in nationalism and the concomitant seeds of racism are beginning to flourish.  Of all dangers in Europe, this is the one with the greatest threat of throwing the region back into its millennia-long history of internecine strife.  And, in the background, has always been a nagging concern that much of the current peace depends on the military support – financial, manpower and ‘suasion’ – of the U.S., both in its own right and through NATO.  Europe, for a territory of its size, has a remarkably ineffective military.  Fortunately, with the U.S. as number one ally the concern has remained buried.  But will the U.S. continue to be there to the same degree? Although there has been sporadic grumbling in the U.S. over its military budget, the power of the military apparatus and lobby, together with a status quo oriented leadership (post Reagan) has resisted major cut-backs; as a result, no one in Europe has really considered the U.S. greatly diminishing its role.  With the Electoral College Trumpeting in a new era, this all has the potential to change.  All of a sudden, uncertainty is the new certainty.  Although, Trump has been tough in his posturing, he has also been hugely erratic; it is this latter set of behavior that opens up a startling level of policy concern for the future.  Leaders in Europe (and elsewhere) can design strategies to react to/handle either hawkish or dovish U.S. leadership.  It is extremely hard, however, to plan for what promises to be a series of possibly contradictory and/or changing postures and policies.  In poker, it is extremely dangerous to play at a table with a highly irrational player (no matter how inexperienced) who has an infinite bank to buy in.

So Europe faces some tantalizing issues.  In an era of budget constraint, outside of the UK, which spends about 2.5% of GDP on military (vs. 4.35% in the U.S.), the next largest spend is France at 1.8%, with Germany at a mere 1.35%!  Bluntly, Europe has leaned on the U.S. since WW2 to subsidize its defense and take responsibility for many potential threats.  ICBM’s apart, Russia is much more of a proximate threat to Europe than to the U.S.; equally so, the multi-pronged Islamic kerfuffle, both on EU’s borders and within many member countries, is clearly of more palpable concern that it is to the U.S., a continent and ocean away.  Action by Trump redistributing the economic responsibility for much of Europe’s military is likely to receive considerable popular support in the U.S., which should raise red flags in Europe.  But what makes the situation even more problematic for the EU, is that , even were it to take on a more reasonable share of the burden, a military force requires almost complete cohesion – something virtually non-existent with the E.U. – both culturally and structurally.  The massive difficulties faced by country leaders on agreeing on (let alone implementing) social and economic issues that are much less dramatic than Defense, show the daunting prospect of establishing anything resembling an effective EU military force.

The Realization – What does all this mean?

So now that the unexpected has happened, the reality has set in, relative calm has settled in, the question is where do things go from here?  The hope would be that this ‘crisis’ will cause all participants to carefully scrutinize the current flaws that exist in the Euro and the structure, policies and administration of the E.U. itself.  Not all those who campaigned and/or voted for Brexit are uninformed anarchists.  Many of the concerns that resulted in the exit vote continue to be problems that will also influence other current (and prospective) members and potentially impair the viability of the EU as a long-term, sustainable option.  These include:

• A plethora (and growing) number of different cultures, all with their own government, needing to come together to set both macro policies and agree on detailed micro issues.

• The vast gap between richer and poorer nations and limited mechanisms to responsibly bring greater parity.

• A diverse set of external borders without a single, clearly operable policy for determining how porous they should be.

• A diverse set of internal borders, with differing opinions on how open those should be.

• The difficulties of having a single currency, without having a unified central government, setting both fiscal and monetary policies.

• Having a currency, with central directives and policies that divide the participants rather than unify them.

• A head-scratching uber-bureaucracy overlaid on what, in many cases, is already a crippling underlying national one.

• The lack of implementable mechanisms to enforce policy.

There has been no shortage of opinion or commentary on all of the above and the many others I failed to include.  Little has been done to address most of these prior to Brexit.  Without needing to be inordinately skeptical, I can imagine that not much (beyond extensive persiflage) will actually take place on these overarching issues post-Brexit.

As to negotiating the practical terms of unwinding the official British membership in the EU and figuring out the future interrelations, there are thousands of practical and impractical details that politicians and bureaucrats will salivate over for the next decade, both for their potential historic importance and also the job security these efforts will certainly guarantee!  Some issues can be parsed out, negotiated and implemented within the EU.  Many others that are beyond the control of Brussels and membership in general, exist and/or will emerge from outside the Union and will impede or, at the very least shift, the efforts of EU policy craftspeople.  In the end, market forces, not policy, will determine many outcomes; as is often the case, economics force adjustments faster than politicians and regulators can implement policies and rules.

There are many serious questions and issues to be addressed.  It is early on in the process and it will undoubtedly be interesting to revisit many of these issues as the unwinding process evolves.

THE CORE AGENDA

Long-term Issues – What are the philosophical actual aspirations of the European Union and how can they be implemented?

• Which countries are the Union’s natural members?

• Can a multi-tiered system work, where there will always be, at best, gray areas between sovereign rights and overarching EU rights?

• How should the Union be governed?

• How should the Union be administered?

• Should there be more centralized taxation?

• What is the military role of the union vis-à-vis individual member nations, in relation to NATO and the U.N. and facing the rest of the world.

Medium-term issues  – Important problems that require solutions, not equivocation

• Does the current governance structure of the Union make sense in how the agreements are written, how officials are elected/appointed and in how the bureaucracy is organized?

• In dealing with both current policies and in response to any future changes, how does one organize and fund and deploy military and police work across internal borders to deal with multi-country issues and overall EU foreign policy?

• How does one structure a system that maintains financial stability when crisis hits a weaker member?  Although this should probably be listed under longer-term issues, there are several current and impending examples that preclude the luxury of leisurely contemplation.

• Given Brexit and some of the reactions this has stirred up in other member nations, what should be the mechanisms to facilitate or prevent change in membership ‘status’ going forward?  The almost inevitable Brexit mess could become an unworkable contagion unless a clear set of preemptive policies and rules are developed for dealing with any other potential departing members.  The current position from Germany and France is: “The stick is more powerful than the carrot.”  To keep members long-term, it would seem sensible to create reasons to stay rather than punishments for leaving.

Short-term issues

• Schengen – Does it stay unchanged? What modifications should be considered?  This could be considered a medium-term issue, but with elections occurring within many countries that could put many xenophobic elected officials in place, there is certainly some urgency.

• Immigration – What are the immediate policies regarding both refugee and ‘normalized’ entry into the EU?   How are quotas set?  How are related expenses funded? Is enforcement a national or supranational responsibility?  Once again, this needs to be looked at both in the longer-term perspective and the immediate, given the large number of recent and potential immigrants.

• Internal security – What further steps need to be taken to strengthen cross-border cooperation in both preventing and reacting to terrorist activity and also in dealing with domestic civil unrest.

• How dominant does Germany intend to be in setting and enforcing policy?

• What will be the posture in dealing with the UK in the Brexit unwind?

CONCLUSIONS ON BREXIT

Brexit came as a real shock to many insiders, if not most.   Many were incredulous that a decision of such long-term significance was not being made by the democratically elected representatives whose job it is to make these difficult decisions.  But this was nothing in comparison with the appallingly bad communication and dissemination of misinformation to the voting public perpetrated by politicians and the media for their own petty short-term gains.  Whether the UK should have remained or not, the process by which this historically significant decision was made was unforgivably flawed.  This does not necessarily mean however, it was wrong.

The UK was faced with a rather challenging dilemma.  Do we remain as part of an organization that is fundamentally flawed and that might suffer a significant downward spiral, but that is ‘too big to fail’? Or, do we go out on our own and see if we can replicate the resilient British spirit that kept the small island nation at the forefront of global politics for so long?  This is most likely a case of choosing the lesser evil.

Nonetheless, I believe the UK has squandered the opportunity to increase the value of an extremely valuable call option.  They already have the huge advantage of an independent currency; they also have a range of concessions versus other full-fledged EU members.  Their relative financial health, their position as the financial center for the ‘bloc’, their significant military capability and their ‘special’ relationship with the U.S. make them very valuable to the EU, both short-term and longer-term.   Used properly, this could have (putatively, still could) provided considerable bargaining leverage to gain certain concessions if they stayed, while still retaining the ultimate card of being able to leave.  Why should one fold a hand, when one has a free turn of the cards?  Dwelling on incompetence, however, is irrelevant.

From here on, it is a question of both negotiation and implementation.  The pre-posturing on the negotiations has been ham-handed on both sides and not an optimistic indicator for the process.  The parallel bureaucracies that need to be created on each and put into effect on each side of the Channel are a daunting prospect, particularly given the lack of effectiveness of many of the existing bureaucracies!  On the positive side, it does generate employment!!  Handicapping the outcomes is, unfortunately, impossible.  In the end, possibly even more important, is the fact that outcomes are not fully determined by the governments on either side of the Channel.  The markets will have their say and influence, as will other players in global geopolitics (please see the follow-up thought-piece for an intriguing scenario).  The only guaranteed winning demographic is the press.  What a field day for years to come…

But Brexit and the EU do not live in a vacuum.   The decisions and actions being contemplated have massive direct and recursive effects on every corner of the globe.  Targeted consequences are many, unintended ones virtually infinite.  The next part of this thought piece looks at Brexit not as an isolated process but as a potential catalyst for much a set of much more global realignments.

CHALLENGING CONVENTIONAL WISDOM.

POTENTIAL GLOBAL REALIGNMENT POST-BREXIT

History is a constantly shifting set of alliances, allegiances and enmities.  There is never a question of permanence, merely the degree of evanescence.  Because changes often occur over a longer span than an individual’s lifetime, each generation, relying on its own set of lived experiences, believes it is able to create a new paradigm where extended stability is possible.  And yet, history has to date, proven this to be an illusion.  Humanity drifts from one crisis (i.e. critical juncture or turning point) to another.  Wars, health crises, climactic disasters line up alongside the rise and fall of leaders, demagogues and the shifts in demographics and technology to see the constant restructuring of geopolitics and redrawing of borders.

Whether Brexit ends up actually being a catalyst to a major geopolitical shift or not, it certainly could.  Many would like to merely see a slightly modified status quo; after all, there is comfort in incumbency.  Those in power are almost always reluctant to cede or even diminish their hold and their advantages.  And so there are many constraints to change – now as always.  Sometimes this is good, sometimes bad.  We live in a world that for a long time has been dominated by the Northern Hemisphere and the Western latitudes.  This Euro/American hegemony has been challenged post WW2; some changes have occurred both within the privileged community and outside.  The most seismic developments have been the rise of China and the overall economic power of Asia as a whole. The relative increase in affluence of other regions, such as Latin America, partially as a result of a prolonged commodity boom, has also been very important.  The vast flow of Petro-dollars and incoherent policy by developed nations has created homes for radical Islam spanning Africa, Europe and Asia.  Although there has not been a major global war since WW2 or a major global political division since the fall of the Soviet Union, there have been numerous regional conflicts and a number that fester and grow around the world today.  These are unlikely to disappear or become more benign.

Regardless of the direction of any one of the current (or unanticipated future) conflicts, the simple fact is the demographics do not favor the incumbent power base.  Both existing population base and birth rates outside the most developed nations make retaining a sustainable edge for the currently privileged hard to envision without either military action or a massive shift in global alliances.  Instead of evaluating the potential for calamitous military engagement, this piece will explore a set of potential new alliances that could rebalance global geopolitics and economics.  Naturally, the likelihood these occur in their entirely is zero; however, some elements bear discussing in the halls of power in capitals around the world.

The discussion is divided into four sections:

1. A dramatic gambit by Europe as a reaction to Brexit.
2. An equally unexpected strategic expansion by the UK.
3. A response by the U.S.
4. A reaction by China.

TERRITORY 1 – The New EU

A World-Changing Alternative – have Russia become part of the ‘New’ EU. I posit this as a paradigm-shifting and potentially viable alternative, although the long rivalries, suspicion, nationalism, etc. make it highly unlikely.   The theory is based on a combination of economic, military and personal interest and exists only because of the personalities of the leaders sitting in the two pivotal seats and the relationship that exists between them.  Without Angela Merkel and Vladimir Putin this combination would most likely be unimaginable.  A private, unpublicized meeting between the two of them in one of Putin’s dachas somewhere in the world could rock the world.  Here is a suggested monologue by Merkel:

1. Vladimir, we both know you are a very smart man; you understand Russia is facing what is almost certainly a no-win longer-term situation.  You run a country, with a large, well-organized military, with great weaponry; however, you face the ultimate challenge – an exceptionally long border, with hostiles or potential hostiles along most of the periphery, with insufficient ground troops to be able to deal with problems simultaneously on multiple fronts. And, Russia has a terrible demographic – a population of less than 150 million, a low birth rate and a low life expectancy. Obviously, you could always press the red button, but that would not make you the winner, only everyone a loser.
2. Your country is still largely a one-trick pony, based on huge resource reserves, but this makes for instability when large swings occur, as they have over the past couple of years.  Given Russia’s ‘track record’ in the financial markets, foreign capital infusions are not dependable and are likely to dry up most at times of crisis, when you need them most.
3. You have a remarkable ability to ‘message’ to your compatriots and gain support for positions you wish to implement.  To this point, it has worked well for you and you have had support for your approach in Syria and the Ukraine; however, eventually, if the economic situation in Russia does not improve, you might run into more difficulties.  It would appear that your longer-term options might be narrowing to some degree.
4. You have been able to amass an immense ‘family’ fortune, which many estimate at $300 billion to $1 trillion.  Whether these numbers are accurate or not, the actual amount is still enormous by any standard, so large in fact that it might be difficult to monetize much of it, were an international effort undertaken to block you.
5. The EU exists to create a trading block that can compete effectively economically with the U.S. and China and which can help provide geopolitical stability to the region.  With the loss of the UK, we have lost some of this strength.  However, if Russia were, over time, to develop an ‘affiliation’ with the EU, we would jointly hold an extremely important economic, resource and geopolitical position in the world.  Following are some of the advantages you might consider:

–       Your biggest medium-term actual defense threat is China; they have an immense army and also a huge arsenal of tactical weapons.  Affiliating with the EU, makes aggression on their part much less likely.

–       You continue to be threatened by NATO, of which the EU is the most proximate landmass to you; being part of us, would allow you to more effectively deploy your military resources to other areas.  Our combined forces and armaments would instantly propel us to the most potent global military defense force.

–       As with us, you face a major (and growing) threat on the radical Islamic front.  Like China, they have a population base of military age that is difficult to confront alone.  A true ‘cooperation’ would enable a better global set of solutions to an issue that is unlikely to simply disappear on its own.

–       You have a well-educated work force, but the structure of your economy, markets and politics still retain strong residual impediments from the Soviet days; this is likely to dampen your progress relative to other areas in the world, particularly if you continue to require a large part of your GDP to be spent on Defense.  You have seen what I have accomplished with East Germany, in gradually raising their standards of living, productivity, etc. and also in starting to remediate ecological and other issues.  Were you to become affiliated with the EU, you could benefit from our expertise and economic power to strengthen your economy.  Our benefit on this front – so you understand our self-interest, are: a huge new market for our products; better access to natural resources (particularly oil and gas) that could lower our current dependence on volatile regions around the world; and, a gradual affiliation with a potent military apparatus.   It would also make us more long-term competitive vis-à-vis the U.S. and China.

–       I could work behind the scenes to assure that many of the assets you have personally acquired remain with your family.

1. I understand the public relations difficulties of achieving this plan.  The ‘dominant Russia’ remains a unifying image for your country, and understandably so.  However, the exact same issues exist for the U.K., France and Germany.   History continually realigns borders and the players change.  None of us is the same as we were.  What I am proposing is a quantum shift going forward, that puts Russia in the heart of an alliance that will clearly be a global super-power.  It also does it in a way that not only avoids war but, could effectively promote peace.  Please understand, this proposal will, in many ways, be even more difficult to achieve on my side, given the number of different countries and different forms of democracy currently existing within the EU.
2. We will carefully orchestrate a plan where I quietly build a supporting group of countries, using both the carrot and the stick; I will probably need to start with the smaller countries which most require Germany’s support; with a meaningful group, I can then work on the larger, potentially more difficult areas.   At the same time, you can start to plant seeds at home.  We can ‘stage’ fights and resolutions that show an ability in the press for us to work together; we can also promote trade, cultural and other arrangements that can be publicized in a way that softens images both in Russia and the EU.

World history changes only when visionary leaders take the helm.  It often occurs through war or stems from crisis.  The idea of bringing Russia into the EU fold would be a diplomatic tour de force by two very powerful leaders and would be a significant step in averting WMD use and resetting global power balance in a largely peaceful way.  And best of all, it originates, not out of a full-blown crisis, but as a result of more tractable economic and social problems in both Europe and Russia, with Brexit being the immediate catalyst and ‘opening’ for discussion.

TERRITORY 2 – The New U.K.

With or without a Russian alliance within the EU, the U.K. finds itself in rather a precarious position.   Since WW1 the U.K. has seen its global influence falter dramatically.  The costs of WW2 (both economic and human) brought a rather bleak period in the U.K. through the 1970’s.  Five things led to a spectacular recovery – at least on the surface:

1. The discovery and exploitation of North Sea oil.
2. A Thatcher-led move towards free markets and lower taxation that encouraged the growth of some post-industrial businesses, particularly in the financial service arena.
3. The favorable tax environment for extremely affluent foreigners.
4.  The growing hegemony of the English language.
5. Joining the E.U. and becoming a magnet for young European professionals, skilled artisans and workers of all types.

These all combined to bring the U.K. back to the forefront and to create prosperity in London and some of the Home Counties, as well as a few other cities around the country.  However, one does not need to dig to deeply to see that although improvements have occurred further to the North and West, the levels of unemployment and income inequality remain very high.  The revenue stream from North Sea oil has been largely depleted, not ‘saved’ and invested separately on behalf of the country and its citizens; and, the risk of severe economic retrenchment in the event of a financial sector crisis or general financial crisis is not insignificant.

A distancing of the U.K. from the E.U. is almost certain to result in a ‘repatriation’ of certain types of jobs to the Continent and the level of economic interaction remains uncertain.  There is also a growing possibility of a full devolution by Scotland, which remains strongly pro E.U.  This all leaves the U.K. very vulnerable.  Nonetheless, it does retain some key strengths:

1. A legal and financial system that is largely trusted around the world.
2. Enterprise management skills that are globally accepted and used.
3. An independent currency.
4. An environment in which it is largely safe to live and is prized by many around the world.
5. A meaningful military presence and a key seat in global political organizations.
6. Favored relationships, stemming from its colonial past with many nations.

Although the population of the U.K. is respectable at about 65 million (including 5 million in Scotland), it is clearly not large by long-term global geopolitical standards.  As part of a European grouping, it was an important part of a significant population and landmass; alone, it really is an orphan – too large to be mono-focused like Singapore, to small to really matter.  Over time, demographics normally end up being the decisive factor.  For the U.K. to prosper over the longer term, it needs to affiliate.  An obvious choice would be to tighten the relationship on all fronts with the U.S.  The clear benefits are a shared language (almost), history and the reality of having been close allies for a century.  The disadvantage is the obvious imbalance of power.  The UK would be destined to a similar fate as the Liberal Democrats (vis-à-vis the Conservatives) in parliament.

A more intriguing alternative would be to take another look at history and reconstitute – on vastly different terms – a portion of the Commonwealth.  If the U.K. were to ally both on an economic and military basis with India (perhaps the other countries of the Subcontinent), Australia (and New Zealand) and South Africa, the agglomeration would represent some very potent characteristics:

• A major population group with overall positive demographics.

• A large percentage of the population with below global average GDP – allowing for significant growth capture over the short to medium term.

• A strong resource base.
• A very strong military.
• A very interesting geographic diversification.

• An ability to attract others into the union over time.

• A generally aligned operating philosophy (i.e. Democracy)

• A longstanding cultural understanding.

Needless to say history also comes with its negatives.  The yokes of the colonial era and the hard-fought independence would not be easily shed.  However, the idea, similar to that of the E.U., of a confederation of equals could hold distinct appeal, particularly given other changes in the global power dynamic.  Also, given the significant differences in competitive advantage, the benefits each brings to the table would lead to a better chance of internal power balance.

For India, the largest appeal would be a more efficient access to and deployment of capital.   Improving the legal system, lowering corruption, improving infrastructure and education could put them in a position to actually realize the goal of competing with China; and, without the one-child policy, ironically, India is in a better demographic position to generate sustainable long-term growth.  Furthermore, a joining of military forces would help India over the longer-term, given its extensive borders with potentially hostile neighbors.

For Australia/New Zealand, the ties with the U.K. are already extremely strong.  The shifting of their major export market from China to India would, most likely, be favored by the electorate, given growing concern over the level of dependence the country has on China.  Also, China’s growing military is likely to be of concern to Australia and a strong pact with the U.K. and India would solidify their position.

As to South Africa, they could probably benefit the most from a close alliance.  Although they remain the least dysfunctional country on the continent, their problems are massive and growing.  Their emergence from Apartheid has certainly removed a yoke of oppression, but the day-to-day lives of much of the population have not dramatically improved.  Crime is endemic, infrastructure in most of the country not close to keeping up with demand, their borders with neighbors quite porous and corruption ubiquitous (particularly within the ruling ANC).  Furthermore, the massive lack of stability on the African continent represents a constant risk.  China’s growing influence in many countries is also viewed as potentially pernicious.

Needless to say, knitting together this alliance with its disparate geography, varied politics, ideologies and character would be a challenge and, perhaps unachievable.  However, with a quantum shift in the global map, this grouping could become compelling.  It would also position the group well to attract significant other ‘independent’ countries who could find membership attractive.

TERRITORY 3 – The U.S. Co-Prosperity Sphere

To the extent a move is made towards a European/Russian merger and the U.K expands, the U.S. is left few choices. Initially it could and, almost certainly, would use its enormous wealth, influence and military to block these moves.  However, were the will strong enough in the other two blocks, the U.S. would be in no real position to do so, without resorting to the type of actions that run counter to the entire raison d’être of the country.  With a hawkish military and an aggressive, but inexperienced leader like Trump, an aggressive approach should not be ruled out; however, our recent military experiences in the Middle East have not been popular.  Although running counter to a central sound bite in the Trump campaign, a much more practical approach would be to enhance the trade alliance that is already in place – NAFTA.  To this point, it has been a trade pact, but could easily become much more meaningful.  Combining the Super-power position of the U.S., with the resources and natural geographic barrier of Canada and the population of Mexico could act as a strong counter to the other two new groups.  Furthermore, in spite of the idea that Mexico is taking jobs away from us, having a closer alliance that enhances the market to the south is more likely to add strong jobs here and solidify our ability to fill lower-end positions that Americans simply don’t want to do (agricultural, etc.).  Adding Brazil to this mix, would be both a strong population, demographic and resource play and the geographic positioning would most likely lead to other Latin American countries wanting to participate.  Finally, with a consolidation of power groups, Japan would be too small to remain independent.  Their strained relationship with China is probably irreconcilable, in spite of geographic proximity and an important trade relationship.  As a last resort, they could also want to be part of the U.S. Bloc.  Their terrible demographics and limited military make some form of alliance critical if they don’t want to be absorbed into China over time.

Canada enjoys its current position of neutrality to the north of the U.S.  Its proximity and cultural similarities to the larger population base to the south make a union natural, although resistance is likely to be high.   Also, with its historic ties to the U.K. – the Queen is still officially Canada’s monarch – there could be a pull to join the new Commonwealth.  However, given geography and the depth of economic ties, the U.S. is the natural choice.

Mexico’s politics have improved over time, but they still remain messy.  The economy is the same, as is overall infrastructure.  From a practical point of view, an even closer alliance with the U.S. would almost certainly benefit the country.  The ability to access and deploy capital on infrastructure could help considerably, as could process management.  A decrease in corruption and more consistent legal system would add stability.  A population emerging into the middle class would be a great market for U.S. products and the demographics are favorable with good growth and youth.  Its geographic position as a bridge to South America is also strategically important.

In a world without official blocs, Brazil is well positioned to thrive independently.  It is the world’s fifth largest country, both in size and population.  It has abundant resources and strong demographics.  The country’s biggest problem over time has been a lack of strong leadership.  This has allowed corruption to thrive and has held back economic and social development.   Brazil has for a long time been the ‘next’ great country.  With the recent extended China-driven commodities boom, it looked like Brazil was poised to make the leap; however, the lack of effective allocation of capital and the leadership vacuum has held the country back and its progress is currently being eroded.  A full-fledged alliance with the U.S. could provide significant mutual benefits.  It is never easy to extirpate an entrenched incumbent, but Brazil’s open press and frustration with its problems could provide an impetus to do so (or conversely to resist).  Nonetheless a strong trade compact could strongly benefit both sides.  With Brazil and Mexico part of the group, it would be hard to imagine other Latin American countries not joining or ending up in a position of ‘favored’ neutrality.

Although Japan’s GDP has continued to grow, it has been losing ground steadily to Germany, and given demographics this trend is likely to continue/accelerate.  Japan faces a true crisis of identity over the next several decades.  A country of great history, culture, wealth, education and productivity, its small geographic size, lack of domestic natural resources and reverse-Malthusian demographics and virtually non-existent military are bad signs for its long-term role in global power brokering.  Since WW2, there has been a love/hate relationship with the U.S.  This is infinitely better than the multi-century ‘tensions’ with its huge neighbor next door.  A carefully crafted alliance with the U.S., as distasteful as it might be with the population overall, would most likely be the least bad alternative for Japan.  The greatest antipathy would certainly come from the 50+ demographic, but their influence will start to decline and the cultural gap between the younger generation and the U.S. is far smaller.   A truly bilateral trade agreement and a well-conceived joint military would almost certainly benefit both sides.  The same would be true with South Korea and, with different leadership, the Philippines.

In the Middle East, the U.S. would like to keep Saudi Arabia and Israel in its fold and expand influence if possible.  Although Iran should be a natural ally, this is certainly not on the cards for the near future.

Like the U.K., the U.S. has a history of cobbling together alliances to ‘preserve global stability’ and/or to promote self-interest.  These blocs are inherently unstable and unlikely to be engraved in granite for ever and a day, but groupings that have balance and well-conceived sharing of influence do have a better chance of surviving than propping up and/or installing demagogues into a region.

TERRITORY 4 – China Evolves

Emerging from a disastrous period of ideological tyranny and massive self-induced devastation, China has been the most important global factor to emerge in the last century.  The pace of its economic development (and to a somewhat lesser degree social change) has been breathtaking and virtually unequalled in human history.  The current outcome was certainly not predicted by many during the Long March of Mao’s leadership. It has brought about some spectacular gains in standard of living for a vast number of people; it helped the global economy expand in unpredicted ways; it has changed the map of global geopolitics.  Needless to say, not everything has been smooth, nor has everything been positive on many fronts.  China finds itself in an interesting position.  The fact it has a centralized and often authoritative government has enabled it to execute plans that would have been inconceivable anywhere else in the world.  It has carried along more than a billion people in geographically dispersed areas that have vast cultural differences – sometimes with a carrot, sometimes with a stick.  It has granted fiefdoms – both political and economic – allowed (and perhaps encouraged) graft and corruption, so long as it fit within Beijing’s overarching goals.  As a carrot, it has lavishly rewarded those who have outwardly been willing to toe the party line.  More importantly, however, as is now quite evident, it has been a way of amassing considerable ‘evidence’ against virtually every official and businessperson in China, to be used when considered advantageous to further party the leadership’s agenda.  The legal system used to be opaque and clearly a tool for those in power who rarely publicized anything but the results of a case and the fate of the defendants; now, there are now clearly written and often well-designed laws covering a vast range of issues and trials of public officials and businessmen are often open to public scrutiny.  Why?  Because, the defendants are actually guilty, by any standards! The laws exist; however, they are only selectively enforced.   The government broadly allows and documents illegal activity; in most cases, when those involved properly toe the party line or don’t otherwise get caught in political or media crosshairs, this ‘data’ remains securely locked away.  This, in the short-term, is likely to be very successful tactic for maintaining ‘discipline’ and keeping real power centralized.  Over the longer-term, however, it is less likely to be successful, as the complex interaction of domestic and international markets, politics and information dissemination, make systems anchored on corruption and coercion virtually impossible to sustain.

Returning to the main theme of this piece, the global jigsaw puzzle.  What does Beijing want to achieve.  Growth, to this point, has largely been internal.  International growth has been economic and China has economically ‘colonized’ a number of resource-rich countries, particularly in Africa.  Going forward, in a scenario of far-reaching global alliances, what would be China’s most effective play?

So, what are those policies in the event of power grabs by the constituencies discussed above?  Given China’s increased wealth and power and its large population, it is hard to conceive the leadership remaining passive, while the rest of the world consolidates. But, who are China’s natural allies and/or targets?  Frankly, there are very few culturally compatible allies.  In the region the most obvious are:  North Korea and Taiwan (after an immense amount of hand-wringing, posturing and play-acting); Indonesia; the Philippines with the current anti-U.S.A. president also represent meaningful and geographically reasonable affiliations; somewhat further afield and for completely different reasons, Iran and Pakistan are intriguing possibilities; Any resource-rich dysfunctional African nation, with a kleptocratic leadership could fit the bill; and, perhaps a disaffected Latin American nation.

The problem with this type of alliance is that China’s centralized control-dependent, ‘iconic’ leadership model is culturally anchored.  It doesn’t necessarily play well in other countries; in fact, in many countries that also have a ‘strongman’ approach, the idea of two strongmen is hard to conceive.  In order to have a global alliance, China would need strong enforcement mechanisms.  They have the population and the capability of building a military to do this, but a world of trade and cooperation runs counter to this approach, leaving most of the countries listed as either independent or seeking other affiliations.

CONCLUSION

As you can probably surmise, growing up, I was an avid player of the game Risk.  Looking at the relative strengths and weaknesses of countries and larger geographic areas has always been fascinating.   As with any hypothesis, the ‘theory’ outlined above is obviously extraordinarily unlikely to come to pass. History, if not random, is certainly unpredictable.  The virtually infinite number of variables and the ever-changing complex skein of global politics make prediction virtually impossible – look no further than the Brexit and U.S. election results.

In looking at the globe today, as always, there are areas of clear change and instability.  Most are local; some are global; others risk crossing borders.  And, as at any other time, there are affiliations, allegiances and enmities.   But these will continuously drift, as sands in the desert.  Why?

• New leaders
• Demographics
• Wars
• Technology
• Natural causes (weather, health, etc.)

 

The shifts are normally messy and most frequently involve power plays and massive death/suffering.  They are rarely in the best interest of the ‘people’, merely expedient for those with the greatest relative power at the time.  In spite of the growth of trans-national organizations like the United Nations – the primary mandate of which is to prevent global conflict – these will almost certainly fail when confronted by ruthless policies by the strongest member(s).  Realism is often confused for pessimism, but primarily by optimists!  The theory of having four power blocs, with each being self-sufficient and able to generate ongoing economic and social growth is a potential way of avoiding armed global conflict.  Furthermore, each would not operate in a vacuum.  There is huge benefit to trade and other forms of cooperation.  A balance of power among four groups, each with strong capabilities and comparative advantage, is most likely a better balancing mechanism and deterrent than a single or pair of super-powers.  It is also positioned to be much more effective at ‘policing’ than either an individual nation or a discombobulated babel of bickering (aka the UN).   Globally dislocating issues, such as the radicalization of Islam, the growth of ‘rogue’ states like North Korea, the export of pollution and other long-term negative externalities could possibly be better addressed.

Naturally, many nations and a large percentage of the world’s population do not figure directly into this four-bloc model.  Over time, some countries might choose to affiliate, be involuntarily subsumed or simply remain independent.  But that is not central to this discussion.  The real key is whether the combined threat to European unity as a result of Brexit, Euro dysfunction and massive internal political tensions within many member countries could be a catalyst to global strategic realignment.   The most likely answer is no.  It seems most probable that everyone will muddle on.  Europe will decline in relative strength, but as the world’s third largest economy, they will still remain a force to be reckoned with.  I still register concern that the growth in political and social instability might pass the point of muddling inflection and escalate into serious conflict.  As to the UK, the combination of having Sterling, being a global financial center and having a close allegiance to the U.S., makes it hard to see a ‘disaster’ scenario; on the other hand, it also seems hard to see a massively positive outcome either!

As always, I welcome any and all feedback and comments both factual and opinions.  Thank you for having had the patience to wade through this tsunami of verbiage!

 

 

 

 

 

 

 

 

THE REAL ISSUES

• Thousands of years of battles over national sovereignty do not end because of a single political and economic treaty.

• Decision making by Committee can barely be suffered during good times – it is completely impractical and intractable during bad times.

• Most European countries operate under heavy-handed bureaucracies on their own; adding a massive bureaucratic superstructure is unlikely to have felicitous economic or social outcomes.

• Inefficiencies can be masked by a growing pie (or rising tide), but become perilous when the pie shrinks (tide subsides).

• Without central control of revenue generation (i.e. taxation), economic control (e.g. interest rate policies) and a large percentage of spending, there is little chance of long-term economic success, particularly regarding policies of ‘redistribution’.

• Borders, both internal and external, are the primary cause and result of war.  To imagine simple elimination of borders without ramification is the optimistic product of an unusually long period of relative peace.

• Planned geographic growth of a region can only be effectively applied when there is a clear purpose and mandate and support by all sides.

• In the end, economics will almost always prevail – if plates are full at the dining table, there are few complaints, when they are more empty, someone needs to be blamed.

These issues are central to a complex skein of geopolitics and economics that underlie and loom over the British Exit from the European Union (Brexit).  As one can imagine, there is a huge amount of emotion on all sides, given the potential stakes and the myriad of possible outcomes.  The uncertainty lends itself to the elaborate concoction of scenarios and often prevarication. The world is complicated and unintended consequences and their follow-on ramifications abound.  And at the heart of the matter, uncertainty begets insecurity and insecurity often begets irrationality.  Unfortunately, there is nothing that can eliminate the current uncertainty.  However, not enough people have fully thought out the actual reasons for their concern.  The decision is of sufficient magnitude that it should not be made based on poor politics or incendiary media.

BACKGROUND

The EU is the evolution of a ‘loose’ confederation of countries that was formed largely by Germany and France in the difficult post-rebuilding years after World War II.  It was a union to secure peace and build economic strength for the region.  At its core, the French needed more financial support and stimulus, the Germans a full political rehabilitation and the others who joined, an enhanced geopolitical stability and economic growth engine of a united trade block.  Then, as now, there were many skeptics, among the largest of which was the UK.  Without going through an opinionated blow-by-blow history of the EU, which has come a long distance, and survived many setbacks the current position remains precarious, because the foundation has never been rock solid.

Providing a fully integrated thesis on the current situation lies well beyond the scope of this type of this article.  The purpose of this thought piece is to provide a framework for readers to organize and integrate their opinions on the current economic and geopolitical realities.

To ruin the ending:

There really are no clear conclusions as to whether the Brexit makes sense for the UK or not!

THE CORE BENEFITS OF HOLDING THE EU TOGETHER AND FIGHTING BREXIT

1. A politically and militarily unified Europe.  Europe, as an ever-changing set of borders, has been a hotbed of war and conflict for thousands of years.  Within often very close proximity, it is home to many cultures, languages and customs, as well as many geographies and climates that have led to very different national and regional characteristics; allegiances and enmities have existed for generations beyond counting and often run so deep, one can even wonder if they have become genetic!  The conflicts between and among countries have arisen for many reasons; some have been localized, some much more far ranging; some quite brief, others lasting many decades.  The bottom line, however, is that for all of modern history, conflict has never been more than a few decades away, somewhere within the continent.  World War I and World War II, created an entirely new paradigm with their almost unimaginable level of carnage and devastation.  The clearly unsuccessful policies subsequent to WWI led to a massively different approach after WWII. The idea of encouraging rebuilding among the vanquished, not just the victors was an anchor to the philosophy.  However, within this backdrop of creating broader stability, lay the growing cancer of the Cold War. Within these historic parameters, the justification for a European union of some type seemed (and still seems) fairly indisputable.  Ensuring long-term that Germany was a controllable part of a greater whole appeared beneficial both from an internal and external political perspective.  Few doubted the German’s ability to rebuild, and having them as an integrated ally rather than a potential foe (a recurring theme over centuries) was important; also, given the proximity of the USSR and its growing, and aggressive military posture, having a strong and dynamic military partnership also made sense, although a more global defense policy, which included the U.S. and NATO made this aspect more nuanced.Today, some threats remain the same, some have attenuated and others have developed more recently (both within the geographic area and outside), but the concept of a unified military and foreign policy block remains as valid as ever.
2. A major global trading block.  When the EEC was originally established, the U.S. was the only dominant world financial power.  Europe wanted to be in a position to compete head-to head.  This made and continues to make considerable sense. Over time, Japan emerged as a credible competitor and subsequently China has seen a meteoric rise and other countries have ridden a wave of commodity-fuelled expansion.  This has threatened to reduce Europe’s relative weight and importance on a global basis.  In response to the mounting competition, the EU has actively sought to increase its membership.  The U.K. is a very important part of the equation, not just because of its population base, but also because of London’s global importance as Europe’s clear financial center.
3. A major mutual trading block.  Increasing trade flow within the EU stands to benefit the region overall.  How this balances across nations/regions is key to its success, with different areas benefiting at different times.   To the extent comparative advantage is encouraged by less protectionism and lower frictional costs (duties, different measurements/standards, multiple currencies, financial regulations) and labor is freer to flow, internal trade should be a major stimulus to growth.
4. Open borders.  In the short term, this leads to decreased bureaucracy and increased efficiency.  Simple examples are greatly simplified transportation of goods and increased flow for tourism, although many other benefits do flow through.  To the extent the overall ‘Union’ is successful, removing geographic barriers should, over time, also decrease antagonistic nationalistic attitudes as well.
5. Fluid labor market.  The ability of workers to move within larger geographic areas to find employment is, conceptually, quite positive.  When there is significant growth, it works particularly well.  Problems are most likely to arise, when overall levels of unemployment are high and/or when the overall costs of sustaining individuals (social costs) are borne largely by the host nation, rather than by a central authority.  Overall, however, labor mobility should over time benefit the EU.
6. Unified regulatory environment.  Rules and regulations are like oil in an automobile – not enough and the engine seizes; too much and the engine clogs.   There are many reasons for proliferation of regulation, some positive (prevention of clear abuses), some benign and neutral, but others more insidious (e.g. deliberate, indirect establishment of trade barriers, etc.).  A successful EU that standardizes rules and regulations across all member nations, and does so with appropriate moderation is potentially great for trade and longer-term social stability.

THE CORE PROBLEMS WITHIN THE EU AND THE JUSTIFICATION FOR BREXIT

 

1. Fundamental ideological differences.  The French are not the Germans and neither are the English.  The Italians are not the French and, furthermore, Northern Italians are not even Southern Italians.  The Scandinavians are not the Greeks and the Portuguese are not the Dutch.  And with the proliferation of new members, the different ‘perspectives’ increase factorially.  Wars have proliferated because of very different views on many topics.  The relative peace and generally increased prosperity since WW II have held fundamental ideological and cultural differences at bay.  However, the relative stagnation of the past few years has begun to scrape away the surface plaster from the underlying cracks.  Manifestations of these tensions are most evident in the rapid rise of nationalist parties/policies (both right and left wing) in many countries in Europe.  The desire to create a ‘union’ that allows these differences to be addressed in peace rather than war is laudatory.  It is just not clear that millennia of differences can be made to go away in the halls of the European Parliament.
2. Massive bureaucracy.  Many countries in Europe (led by France) are near the top of the global charts in terms of percentage of the workforce employed by the public sector.  These folks need something to do, so they create rules and processes then ways to administer and enforce them; then they need to evaluate them, adapt them and reevaluate them, etc.   Not surprisingly, this not only creates massive direct costs (paying the bureaucrats), but the even greater problems of what is needed to understand and comply with these regulations.   Large businesses often vote with their feet and look for jurisdictions with less onerous procedures.   Small businesses often simply fail or just do not get off the ground.  The reasons for many specific rules and regulations start with the best of intentions, but we all understand where the best of intentions can lead…  As in all things, a balance is necessary; for anyone trying to run a business in many jurisdictions within the EU, it is clear that the balance has long since been passed.  The added burden of an EU infrastructure makes things even worse.  At present, it appears that things are, in fact, moving in the wrong direction – expect more impediments, not fewer, if you intend to transact within the Eurozone.
3. Poor structure for effectively redistributing resources/wealth among members.  The EU has evolved without having created a structurally sound approach to handling ‘crisis’ in the economies of its members.  There is no reserve of sufficient size, even to handle the insolvency of one of the smaller members such as Greece.  The level of handwringing and conflict that has emanated from the internal debate on what to do with a country without the resources or resolve to fix its own problems (or a currency it could devalue to attract external investment) clearly illustrates virtually total procedural incoherence.  In the end there is a free-for-all debate, significant brinksmanship and the economic gorilla in the room setting the tone for policy.  To some extent, having Greece as the trial balloon is not a bad scenario to help establish a better working process; unfortunately, there appears to be little progress actually achieved.  If/when Spain, Italy or France approaches the brink, there is little that could be done – and then what?  If you are a richer nation within the union, the downside risks on forced subsidy are real and quite high.  Great Britain is keenly aware of this.
4. A confusion of different laws and regulations in individual countries masks potential benefits from centralization.  The argument above for one centralized set of policies is a hypothetical.  The reality is much confusion, duplication, contradiction, etc.  Candidely, this is not the best of all possible worlds.
5. Immigration.  This is a very tetchy topic and getting more so.  Different countries and cultures face the challenge differently.  The problem with the EU’s necessary one-size-fits-all approach means that the solution, almost axiomatically, actually fits no one at all.  Most countries would like to set their own policies, but cannot do so.  Although, this should not be a core issue, because of terrorist activities, it is the topic that will most influence the Brexit vote.
6. Open borders.  The flow of EU citizens across borders, while conceptually a great idea to build trust and lower animosity, has in fact become an area of significant contention.  The idea of foreigners (other EU members) ‘taking’ the rightful jobs of locals has become very contentious.  And this is nothing compared to anger and fear of immigrants (both legal and illegal) having free run across the Eurozone.  This started as an economic fear, but with the succession of terrorist or terrorist-inspired events, the fear has become much more tangible and visceral.
7. A largely ineffective collective defense/military.  If reigning in the historically recurring military ambitions of Germany is the primary objective, then the military cooperation has been successful.  With regard to handling external issues and threats, the jury remains quite skeptical.  The lack of effectiveness in dealing with the former Yugoslavia or, more recently, Syria and the Ukraine, must raise questions on both its economic and practical validity.

CONCLUSIONS

 In theory, it should be a no-brainer for Britain to remain in the E.U.  Having a second major Western super-power should be good for local and global stability both on a geopolitical and economic basis.  In practical terms, Britain is not a small country, but its ability to maintain the niche it wants (i.e. that of a ‘global’ power) over time, as an independent country is unlikely.  Blending its set of strengths with those of Germany and other nations in the EU, on paper, is a win-win situation.

However, the foundation on which the entire EU is built has many flaws, as it is based on many layers of compromises, rather than solid unitary thinking and long-term sustainability and flexibility.  Whether this entails governance, regulation, finances or any other aspect of the union, remaining is based on faith that the current flaws will be remedied, the lacunae filled in.  With a growing number of member nations and increasing disparities within existing members, the ability to effect meaningful and effective change becomes even more difficult.  It is, therefore, not surprising that many do not have this faith.

Great Britain’s geographic separation (together with a strong navy) has provided it some buffer from the continual historic border vicissitudes on the continent.  It has also contributed to perhaps a greater sense of self-dependence and independence.  A vitiation of its powers to determine access to its borders is, therefore, an even more sensitive topic than for the other proud European countries with long histories.

Furthermore, over the past several hundred years, the strong engrained belief that a combination of self-determination and ingenuity leads to success, although somewhat attenuated with its more recent moves towards social democracy, is at strong odds with the bureaucratic administrative approach espoused by many countries on the continent and by the EU governing body itself.

It is hardly surprising, therefore, that emotions are running so high.  They often do when the repercussions of a ‘victory’ by either side involve so many negatives and so much uncertainty.

It seems a shame a decision of this magnitude is being taken at a time and within a context that secondary issues (such as immigration) dominate the debate.  I cannot understand why Cameron does not, in these closing hours, meet in private with Merkel and seek to do what leaders do which is to make the decisions for which they were elected, rather than putting that onus back on an electorate that does not have access to enough of the information to make a reasonable decision.  The framework is simple:

 

1. Make it clear that if Cameron leaves the room without the necessary agreement, he will publicly change his posture to support Brexit and the referendum’s conclusion will therefore be set.
2. Put forward a set of demands that show clear reasoning and address the areas of greatest concern today, even if they are in conflict with the current goals of other EU members.  The clarity of presentation is extremely important, to allow face to be saved on the other side.
3. Offer a more limited set of concessions, that do not nearly balance the scales, but once again allow face to be saved.
4. Set a clear sunset provision (such as five years) and propose a defined mechanism for how the negotiation will work between now and then.  Part of this will be a commitment that, at that time, the decision will not be made by referendum.

INTRODUCTION

It seems no one today around the world is without an opinion about China and the Chinese.

• They are stealing our jobs
• They are bailing out the West
• They are destroying the planet
• It is unbelievable how fast they have left Maoism behind
• It is incredible how much power the old-guard Communists have retained
• They are putting out PhD’s at an unbelievable rate and are moving too fast up the ‘food chain’
• Their need for critical high-end input items creates opportunities for everyone
• Their human rights record is horrendous
• They have opened up to outside influence more intensely than anyone could have anticipated
• They have transitioned towards a market economy at breakneck pace
• Real power has been retained in the old SOE’s and among a selected elite
• China represents the greatest military threat to global stability
• China represents a potential balancing foil to U.S.-based military hegemony

These thoughts address only a fraction of the areas in which China touches the world on a daily basis.  As an outsider, with no actual current engagement in the region, but with a history of travel and related business activity, I find it very interesting how analyses on the region – its politics, economics and social trends – tend to be either grossly over-simplified or conversely, extraordinarily over-complicated.  This piece is designed to provide an overall framework for viewing critical issues currently confronting China, its leadership and its people.  There is unlikely to be any aspect that is new or revelatory – the goal is simply to bring together and organize in a readily digestible format, some knowledge from a diverse group with knowledge of and experience in the China of today.

The paper will be divided into five sections:

1. How China has reached its current position – a brief synopsis.
2. Internal and external issues confronting China’s current leadership.
3. How the current political system actually works and why centralized control can survive.
4. What needs to happen to enable China to be a long-term globally interactive superpower.
5. Overall conclusions and recommendations regarding investment and business activity by foreigners in China.

China – a Brief Synopsis

China has one of the longest documented histories in the world (with written references extending back at least to the Shang Dynasty (more than three and a half millennia ago) and has at various times been a leader in areas of military, politics, literature, art, cuisine and essentially all areas of human endeavor.  Over the centuries and millennia, it has brought together a host of different cultures and ethnicities and has had a large population relative to other extant cultures during most periods.  Governing structures have varied, depending on the dynasty, with many being centralized.  However, given the geographic dispersion and the lack of ready transport (even today in some regions), there has most frequently been either explicit or de facto regional and local control.  Nonetheless, in order to keep unified the rambling diversity that was and is China, expression of power has needed to be manifest.  Rebellion and dissent have been handled ‘firmly’.  Today, in spite of the global press’ focus on acts of repression (particularly in regions such as Tibet), this has been a period of almost unparalleled restraint in terms of military and police action within China’s borders.  Given the pace of change in every aspect of Chinese society, this restraint is actually remarkable.

To outsiders, observing the evolution of Chinese geopolitics, the country can appear schizophrenic vis-à-vis foreign relations.  China has had periods of strong external trade and communication and others of state-fostered introspection/xenophobia.  However, this has largely reflected either perceptions of political exigency, or the personality of the emperor at the time or both.  Some ascribe isolationist policy to an inherent genetic trait – a China ‘gene’. Yet, two things would bely this criticism:

1. The diaspora of Chinese emigrants and exiles across Asia (and the world) and their relative level of success in widely differing cultures; and
2. The fact that during periods of historic strength (e.g. the Tang and early Ching Dynasties), China did reach out either in forms of trade or military activity.

Regardless, the swing of the past couple of decades from a hugely isolationist policy, with aggressive external conquest the main form of international communication, to a relatively militaristically benign (at least on the surface) approach with massive trade and global communication is truly extraordinary; to many of us studying China over years, virtually inconceivable.

Absolutely nothing is absolute!  The U.S. most frequently, but colonial powers in general, are accused of ignoring context.  Everything is seen and must be analysed through a specific lens.  Therefore, use of force by the U.S., U.K., Germany, France, etc. is viewed as necessary and justified to preserve global democracy, while actions by Iran, the ex-Soviet Union, China, etc., merely as a form of self-serving aggression designed to destabilize the world!  There is much to be said in favor of varying gradations of democracy, but the context and application is extremely important.  Most of the countries espousing a broader dispersion of power went through periods of massive instability, often lasting more than a century, as they shifted from agrarian to industrialized urban societies.  This often resulted in wrenching civil wars, considerable bloodshed and this frequently occurred in nations with relatively homogeneous populations and often constrained borders.  The issues facing China have not been limited to mere industrialization, but also reflect major issues of population, infrastructure, food production, health, etc.  Attempting to conveniently squeeze Chinese politics of today into Western policy pigeonholes is naïve at best, patronizing, unrealistic and dangerous at worst.  Please do not take these statements as those of an apologist for actions that are often not long-term productive or even acceptable – merely as reflections on a group of very focused bureaucrats/technocrats, trying to achieve centuries of change in mere decades, with the expected concomitant error rate.

In China, democracy has never been the operative system nor (until recently) even a highly debated concept.  The Chinese consider democracy an individualistic paradigm, whereas the overarching ethos of China is that of a gregarious society, where the group is more important than the individual and order needs to be maintained (at whatever cost) to provide stability and progress.  The country’s geographic position and geopolitical evolution have made sustainable control the policy cornerstone.  China has faced a myriad of threats from outside and equally intractable issues internally, including the practicalities of feeding and controlling a large, dispersed population, with huge infrastructure challenges. Even in comparison to an often brutal past, the 20th century represented a particularly harsh and challenging period for China and most of the Chinese people.  It began with a weak Ching dynasty that saw strong foreign incursion, followed by Civil War between the Nationalists and Communists, then an appalling occupation by the Japanese and culminated in the brutality of the Mao Dynasty (during which it is estimated as many as 80 million died, either through military campaigns, murder/death in incarceration or policy-induced starvation and/or healthcare privation).  These decades saw not only the repression of a highly skilled and cultural elite, but a complete stagnation in the education of at least two generations.  For 26 years there was extraordinarily brutal control that effectively stifled any form of dissent, independent communication or progress.  The Communist Party’s ability to clamp down and stifle any form of unsanctioned press and to prevent the dissemination of any foreign media, dramatically enhanced the effectiveness of their propaganda machine.  To those of us in the West during the 1970’s, it would have seemed inconceivable that there would be any form of rapprochement during our lifetimes.    It would have seemed equally extraordinary that many of the Red Guard thugs, who had terrorized their compatriots and destroyed a huge amount of an extraordinarily rich patrimony would become university graduates, fluent in a foreign language, a mere decade after the change in regime, with their kids studying abroad, listening to western music, watching foreign movies, using Apple products and becoming the largest consumers of many European luxury products!  It would have seemed equally extraordinary that a rampant growth in population could have been brought under control, that starvation greatly diminished, basic functional healthcare established throughout most of the country and that China would completely overshadow the rest of the world in terms of infrastructure development.

And crucial elements remain from the times of the Red Guard.  On the one hand, during that period the Red Guard was ‘programmed’ to challenge and destroy the previous educational system and values, tasks at which they were highly successful.  On the other hand, for those living under the Red Guard, survival was goal number one, through awareness, cunning, resourcefulness or whatever it took!  And, for those who survived the regime, these ‘skills’ have not been lost under today’s much freer and more benign politics.  This has left a country, where the value system had been based around a Confucian ideal rather than an enforced religious doctrine, without any real historic values and with very few in a position to pass on what might remain of them.  The country seems largely composed of ‘survivors’ without a clear moral compass, a whole new generation without mentors to establish the basic values of what is right and what is wrong and opportunists (either of Chinese heritage or not) entering simply to take advantage of an economically appealing situation.  Much has been said about the shortcomings of China’s implementation of a legal system; yet, the most effective legal systems require some underlying moral code for them to gain any form of real traction and one of the biggest concerns over the next three decades is whether anyone actually will believe in the system.  Although many of us in the western world might not be active participants in a religion, most still retain some affiliation and are at least influenced by the concepts of guilt and the ‘potential’ for consequences of today’s actions in the hereafter.  In practical terms, the Chinese revolve much more around ‘face’, how one is perceived today.  As such the moral underpinning is simply not to be caught or exposed!  Power and influence provide tremendous shields and those who benefit from these are quite naturally rather resistant to losing them.  This makes practical application of the legal system very difficult.  Furthermore, until recently, judges were primarily former army officials with little legal training – their main qualification being card-carrying members of the Communist Party.  The bias to protecting the interests of the Party and those affiliated remains a major stumbling block to an even-handed and properly implemented legal system.

It is with these immense macro elements in mind that one must evaluate China today.  Those on the glass half empty side, are often fully justified in their concerns/criticisms; and, in my opinion, the willingness of dissenters to push the envelope and challenge the Administration will be a crucial element to establishing an appropriate balance and thereby maximizing future gains for the country. Yet, given the unbelievable amount of change that has occurred and the pace at which it continues to happen, it is unrealistic to expect everything to move smoothly and without problems and setbacks. Stay tuned for an exploration of many of the constraints currently facing leadership in Beijing and around the country.

Internal and External issues confronting China’s leadership

INTERNAL

Power battle/Internecine political strife.  No country glides by without battles for internal control.  The U.S. is engaged in a take-no-hostages, bare-fisted brawl between Republicans and Democrats, without even a clear, definable agenda on either side.  And this exists within one of the most transparent political systems in the world.  China has always been a manifest example of the iron fist – sometimes with a velvet glove, other times without.  The prize from control is a level of nepotism only imagined in most developed countries.  The level of privilege accorded in the past to those with power was extraordinary; this remains the case today; but, instead of representing merely a differentiated way of life, it now translates into virtually unlimited material wealth, both domestically within China and exported surreptitiously (but in plain site) to investment havens around the world. Often the father has the power, but does not actually personally realize financial gains; his wife, children and relatives are those who accumulate the wealth. The battle is being fought on many dimensions, but the two major ones, unsurprisingly, are for control and for ideology.  Although personal advancement remains virtually ubiquitous as a motivation, there do remain ideologues who genuinely see rampant capitalism as an evil approach, a viewpoint that certainly can be substantiated by many data points not only abroad, but at home over the past couple of decades.  The movement towards socialism/communism, as a reaction to repression and concentration of wealth, education and control, is understandable and even laudable; its appalling implementation is less to be commended.  Yet, there remain vast income, wealth, education and power disparities in the current quasi-capitalist approach, that leaves the door open for many ‘old school’ participants, who either remain ideologically pure or merely see forceful upholding of socialist principals as the most expedient approach for regaining/retaining power.  At either ideological extreme, the risk of social unrest is extremely high and this remains a major area of concern for the current regime.  Progress and political survival depends on carefully avoiding excess displays of rebellion on one side and suppression on the other.

Corruption.  This could be a significant detractor to long-term development, while it is a crucial tool for the regime to achieve shorter-term goals.  This is discussed at more length later in the letter.

Labor.  The primary element that has allowed China to explode onto the world stage has been its seemingly endless labor pool at costs hard to beat or equal and limited ‘restrictions’ on use (e.g. number of hours worked, work conditions, exposure to toxicity, etc.) The movement, particularly in the southeast of workers from the farm to cities has to date been able to feed the demand, particularly with easy access to ports. Now capacity is straining and Beijing is trying to address a number of issues simultaneously:

1. There are now periodic shortages of labor in cities with large manufacturing facilities.
2. The increased cost of living has put a strain on workers and has led to increasing worker demands.
3. More open media and internet has made workers more aware of their own condition.

This is leading to pressure to increase prices, something that Beijing is hesitant to do, given the need to keep people employed and the price elasticity of demand for the products they produce, particularly given labor competition from Vietnam, Cambodia, Bangladesh, etc. In order to provide more labor supply and also to better distribute industrialization across the country, there has been a huge effort to improve infrastructure in many inland provinces. However aggressive the effort, it does take time to build roads, railways, airports, housing, schools, hospitals, etc. And, as the clock ticks, there is no question the government is sensitive to potential for mass disruption if employment is not only maintained but improved.

Ethnic diversity/control.  Unlike the United States that effectively has two borders (three if one includes Alaska’s proximity to Russia)  – a large, under-populated and much aligned neighbor to the north in Canada and a relatively short frontage with a relatively weak and disorganized nation to the south – China borders 14 countries (the most of any country in the world), many of them volatile, including Russia, India, Pakistan and North Korea!  Within the country there are 56 recognized ethnic groups, speaking a total of 292 living languages (Jurchen being the 293^rd, but officially extinct)!  Outside of very culturally distinct provinces there are five autonomous regions (Tibet being the most externally known) that represent 45% of the landmass of China!  Although the Han Chinese comprise more than 90% of the population, the other 55 ethnic groups make up a population of significantly more than 100 million people.  Perhaps managing this is not as intractable a task as in India, but it is certainly not a walk in the park!  Under a regime with very strict controls and a limited telecommunications infrastructure, keeping order was largely feasible. In an atmosphere of liberalization, with ever less controllable sources of information, the government has a rather more complicated job.

Income disparity.  This is an issue confronting most of the world, as a growing number of those at the top get more and more relative to those at the bottom. Perhaps this is merely a perception issue (with income disparity always extreme), as media has made the availability and dissemination of this type of information much more common.  Historically, countries like China had particularly limited media,  largely controlled, low levels of literacy among the poorest and strong governmental control.  Furthermore, with survival the biggest concern among the poorest, focus on wealth disparity as an issue rarely surfaced.  With China’s massive leap forward, through industrialization, urbanization, national wealth creation and increased information flow, the debate on the wealth of the richest and the hardships of the poorest is becoming more active and, given the size and dispersion of the population, is one of the governments most intractable issues.  Growth rates in China, together with RMB exchange rates are an important issue for the U.S. and other countries, but for Beijing they are pivotal and central to policy decisions that are contemplated and enacted.

Controlling urbanization.  Taking city dwellers to the provinces for socialist re-education seems a rather distant relic, as the flood of migrants to urban areas increases.  In 1980, approximately 20% lived in cities, today it is about 50% and continues to grow.  By 2025 it is estimated in China there will be 221 cities with more than one million inhabitants  – there are nine in the U.S. today!  The reasons are varied, but grounded in the improved efficiency of an agricultural sector that can better support an urban population, the continued perceived (and actual) massive disparity in quality of life between cities and poor rural areas and an increase in awareness through media and telecommunications. This flood of rural poor into cities is common to most emerging nations, but is rarely particularly well handled.  The mega-cities that have spawned around the world – Mumbai, Sao Paolo, Mexico City, Cairo, Johannesburg, etc. – have huge festering slums and infrastructure not nearly sufficient to meet even basic needs for many of their residents.  Officials in Beijing and around China are more than aware of this and do make efforts on both major infrastructure programs and also on controlling the flow of rural workers into cities.  China has seen particularly large growth to its coastal regions – as a result of its creation of special economic zones to address the surge in production for global trade; however, much of the population lives elsewhere and the government has been making efforts to grow cities in other parts of the nation.  However, for this to be successful, transportation and related infrastructure is necessary; hence the vast spending on highway, rail, ports and air hubs.  China, more than most other countries, has mechanisms in place to control the flow of population.  Their Hukou system, which requires individuals to obtain special permits to officially relocate to a new place on a permanent basis, are relatively effective over the longer term.  Under Mao, violations to sanctioned movements were frequently dealt with in the harshest terms; today, it is dealt with economically, through limiting access to housing, education, etc. Only those with the proper permits need apply.  Naturally, the system is imperfect, the ‘floating population’ is estimated at more than 200 million, and the country’s corruption infrastructure has mushroomed.  Although the existence of the system is now a topic of debate, particularly outside of China, the liberalization trend is meaningful and the results relative to other rapidly evolving nations are certainly strong.

Population size/growth/aging.  China competes with India for the title of the world’s most populous nation.  This has both negatives and positives and represents opportunities and threats.  Current population is estimated at slightly more than 1.3 billion, up from 563 million in 1950, but slowing. The birth rate is about 1.7, which is below long-term sustainable levels of 2.1, but still represents slight current growth, as a result of improved healthcare and some immigration.  Much of this has to do with the highly publicized one child policy and the more benign realities of urbanization and broader education.  Population is expected to peak in around 2030 and then slowly decline (thereby giving the population title to India, that is less organized in its approach to growth).  No matter how one looks at it, this is a huge number, requiring massive logistics to deal with food, shelter, education, healthcare, transportation and growing consumer needs.  Balancing the size of the total population against the composition of the population will be one of China’s bigger problems going forward.  For the moment, however, it appears the more immediate issues are being tackled first.  Nonetheless, everyone is aware there are basically no pensions and little confidence there will be in the foreseeable future; as such making money here and now is particularly important.

Infrastructure Development.  For a diverse set of reasons, both obvious and more subtle, and clearly not directly applicable to this discussion piece, the period under Mao saw little on the front of infrastructure evolution; in fact, it saw mainly a combination of decay and actual active destruction.  With the shift in policy away from radical ideologically-driven communism towards a more market aware culture, with a clear goal of decreasing the crushing poverty of the rural peasantry and the stagnant quagmire of urban life, a clear decision was made to increase productivity.  This naturally involved an extremely broad-ranging set of agendas, ranging from improved food production, reconstitution of SOE’s (State-Owned Enterprises), improved financial system, etc.  However, a common obstacle to almost all other policies, was a crumbling or often non-existing infrastructure.  It is the curse of most emerging nations (and, frankly, many developed ones).  Chinese leadership made infrastructure development a core and pivotal element in their move forward.  This has entailed an across-the-board sprint in every imaginable sphere: roads, ports, railways, airports, energy, water distribution, urban renewal, agriculture, hospitals, schools, etc.  China rapidly has become the largest consumer of steel.  The same has been true for a wide range of commodities, making China the pivotal price setter, thereby influencing much of world supply and demand and thereby becoming an important factor for consideration in the policies of other major governments around the world.  At home, one of the biggest potential drawbacks in the frenetic pace of this development is that it represents one of the largest ‘land grabs’ in history, with corruption playing a part in virtually every facet of any project.  Continued unabated, this is most likely to lead to an extensive range of highly unprofitable projects, often with corners cut that might detract from their longevity/sustainability and also might result in undesirable shorter term disasters – the recent high-speed train accident being a case in point.

Energy.  China is by far the largest producer and consumer of coal in the world.  Having been a major exporter, it is now heading towards being a net importer of the commodity.  This dependence on coal is the primary reason China is the world’s largest emitter of greenhouse gases (not per capita, but in total).   Oil use has also increased dramatically, as has natural gas.  Other sources such as hydro-electric, wind and solar are growing significantly, but (as in the United States) represent a very small percentage of total use.  Plans for nuclear expansion were curtailed post Fukishima.  Although, per capita, significantly behind the U.S. and other developed nations in energy consumption, the rapid pace of industrialization will continue to necessitate heavy production and imports of energy.  Securing sources is of key strategic importance to the Central government.  Although the only emerging nation to have a meaningful policy and position on global warming, this is unlikely to have a major impact over the short-term on real policy decisions.

Food production.   China has a relatively small amount of arable land per capita, making efficiency key to supporting the country’s food needs.  When the Communist Party prevailed in the Civil War, it confiscated land from landlords and redistributed it to 300 million peasants; this ownership structure, however, was short-lived, as the Party gradually created collectives and then as part of the ‘Great Leap Forward’, into communes, where private food production was prohibited.  This was largely responsible for the Great Famine, but the communal system remained in place until the early 1980’s when, under the ‘Four Modernizations’ regime, ownership was gradually given back to individuals.  Strict quota systems and artificial price setting mitigated improvements, but since 1993, when these were relaxed, 90% of annual agricultural production (according to Wikipedia) is now sold at market prices.  China’s focus on irrigation projects, including the massive Three Gorges Dam, has also led to significant improvements.

The overall picture, however, is not all positive.  China remains very susceptible to Mother Nature, particularly to drought.  When there is insufficient rain/snow, there is now the possibility of releasing vast amounts of water from dammed reservoirs; however, this then leads to potentially diminished hydro-electric power – thereby impinging on another of China’s crucial needs for development and stability.  Furthermore, aggressive farming techniques, including the use of harsh chemicals is leading to a diminution soil quality that could lower future acreage and yield.  Also, toxicity levels in agricultural production are of growing concern.   In the short to medium term these issues are likely to worsen.

As an additional current problem, although marked improvements have been made to the country’s, physical infrastructure, there are still severe food distribution issues.  Some of these are caused not just by poor transportation, but by lack of sophistication in marrying supply and demand and in managing logistics.  The good news on this front is that many of the problems can and will be addressed, thereby improving consumable output numbers over the medium term.

Water and Air .  China faces water issues, not just for agriculture, but also for consumption and industry as well.  The battle operates in three-dimensional space: quantity; quality; and cost.  As discussed above, the quantity issue remains a problem (e.g. Beijing water reserves are down by as much as 70% in the last five years) and, as in many other countries (the U.S. included), there are massive battles as to the best use, with massive economic motivation by many individuals to resist ‘best use’ approaches.  China’s situation is exacerbated by still limited (though improving) wastewater treatment and by what is generally acknowledged as potentially crippling levels of increased industrial and agricultural water pollution.  These are not surprising, given the rapid level of industrialization and increased GDP per capita, but given the size of the country and its population, the issues are gargantuan.  From the rest of the world’s perspective, they are also very problematic, as pollution represents one of the least desirable Chinese exports.  Coastal China does have the ability to build massive desalinization plants, but the costs – although decreasing – still remain very high and the process is normally very energy intensive.

Air pollution is ubiquitous and highly visible.  In major cities, the air is literally so thick you could cut it with a knife.  On a moderately bad day in Beijing, it smells and feels as if tires are being burned on every street corner!  According to the World Bank this leads to hundreds of thousands of premature deaths a year, primarily from cancer and cardiovascular disease.   Once again, the problem is not unique to China, but its vast increase in industrial production and energy use makes it the world’s number one pollution concern.  The government is addressing the problem, but is caught in a no-win situation for the foreseeable future.

Control of Information.  Although the government still exerts strong control over traditional forms of media and education and for the moment on social media and the internet as well, the latter are of major concern, as they are almost impossible to fully control let alone extirpate.  The ineluctable progress of technology will almost certainly provide a forum for discussion that might be at odds with government policy.   In the meantime, the central government is not only looking at how to stop others from using the internet and technology, it is conducting aggressive programs (domestically and apparently internationally), both overtly and covertly, to collect information and aid in implementing policy objectives. How Beijing handles the balance of defence and offence will be very interesting to see.  With the clear recent history and mixed (largely negative) results of the Arab Spring, the Party has much to be concerned about and deal with.

EXTERNAL ISSUES

Borders.  Along with Russia, China has one of the two longest land borders in the world (who wins depends on the sources used).  In any case, having 14 neighbours presents a real challenge and this does not include traditional rivals such as Japan and now, with territorial disputes, South Korea as well.  The geography and topography is very diverse and national security remains a key concern to leadership.  This is exacerbated by China’s internal ethnic diversity and the worry that externally generated conflict might have rapid internal contagion.   Although the size of the People’s Liberation Army has been decreased, it is still the world’s largest army at around three million, with a standing army of approximately 2.25 million.  Although certainly not the most modern, a considerable amount has been spent to modernize the force, its technology and its equipment.  What is extraordinary, however, are the 600+ million men and women defined as ‘fit for military service’!  China’s active growth of its maritime and air forces, together with a focus on sophisticated weaponry and growing financial strength puts China front and center in terms of future global balance of power.

Use of Military.   Although included in the external section, there are many uses of military, not all outward facing. The four most important are:

1. Maintaining internal order.  Because of the quilt-work of cultures and ethnicities that has comprised China for so many centuries, the military’s greatest function throughout most of history has been to establish/maintain cohesion within the country’s borders.  This has often been extremely brutal.  Today, the army remains a visible presence and its current role seems more to represent a threat of suppression, although that does not mean it is not used when deemed necessary.
2.  Defense.  This is a broad term that often masks preparation for hostile activity.  Nonetheless, over the course of history, no major nation has survived long periods without a strong defensive force.  China has engaged in many tactics over time, including building the Great Wall, introducing cavalry, developing gunpowder, etc.  With the country’s growing prosperity, China’s military stands to benefit materially.  The efficacy of the force depends on many factors.  The PLA’s greatest function for a long period of time was to preserve the ideological purity of Mao’s communism.  With the cooperation of the Soviet Union, the army started to shift towards better organization and function, but ideology prevailed and relations with the USSR declined.  More recently the move has been to downplay the heavy-handed use of military to enforce political viewpoints.  However, the generation of hard-line ideologues is not yet extinct and some risk remains of a reversion.  It is too early to tell with the new regime, where the balance will lie.  Nonetheless, for a country where signalling is often as important as action, it is interesting to note that the lyrics of the national anthem remain:
   Arise, ye who refuse to be slaves;
   With our very flesh and blood
   Let us build our new Great Wall!
   The peoples of China are in the most critical time,
   Everybody must roar his defiance.
   Arise! Arise! Arise!
   Millions of hearts with one mind,
   Brave the enemy’s gunfire,
   March on!
   Brave the enemy’s gunfire,
   March on!
   March on!
   March on, on!
3. Means of strategic and tactical expansion.  Given the length of China’s history and the military and organizational prowess it has demonstrated at different times, China has been relatively non-expansionist (do not tell this to the Tibetans and other absorbed regions).  At different times, it has absorbed new territories, but it appears that most of its military efforts have been in keeping these, rather than in using them as steppingstones towards global hegemony.  During the post-WW2 period, China was very active in supporting communist governments throughout Indochina.   This can be construed either as expansionist, or as defensive against the encroachment of traditional Western powers.  China’s support of North Korea today is an interesting vestige of that era – reading the tealeaves of their interaction there is important to understanding their policy direction. Regardless, China is entering a period of potentially great prosperity.  This will allow for considerable incremental spending on military activities.   Under relatively benign leadership, this is not necessarily a direct external threat; however regimes evolve and leaders change…
4. Preservation of interests outside one’s borders.   With China’s increased global trade, increasing dependency on foreign resources and foreign ownership, it would be naïve to believe there will not be a concomitant increase in paramilitary/military presence in areas of strategic importance to them.  This has certainly been the case over the centuries, whether Roman armies, Hun hordes, European colonial powers or U.S. capitalists.  It is a matter of necessity to preserve self-interest.  Although China has virtually no permanent bases abroad, they have expanded their navy (although still not a global threat) and they have deployed paramilitary forces to protect interests in Africa and Latin America.  As they continue to bring cash into the licit and illicit economies of many emerging (or static) nations, their influence is likely to increase dramatically.

Regional relationships.  China has had tenuous relationships with many of its direct and regional neighbors.  Prior conflicts with Russia (and its satellites), Japan, Korea, etc. and strains with India, Pakistan, etc., put Beijing in an interesting position.  China’s economic growth has been a boon for the region and has resulted in economic stimulus for many countries, yet the level of mutual trust remains low.  Ongoing territorial disputes (for seemingly incidental islands) and military confrontations have raised regional tensions.  Coupled with an understandable unease with Russia and the potential of a longer-term conflict with the other major population base (India), Beijing has an interesting set of dilemmas.   This is exacerbated by the country’s interactions with Western powers that still have disproportionate control of global economics and politics. Balancing the short-term need for strong economic growth, with longer term planning issues, is something that a single-party centralized government is better positioned to do than most.  Yet, there is no easy solution, as outcomes are extremely path-dependent and even short-term politics around the globe are very hard to read.

Economic Role in the World.  China has made the transition away from a country with virtually no global economic footprint or impact (outside of its long-entrenched emigrated diaspora) and yet an important role as a major international security threat.  It is now the world’s most potent growth engine, a crucial trading partner for developed and emerging nations alike, and an apparently more benign (perhaps simply less overtly threatening) military power.  It has sought to distance itself from economic programs that proved to be disastrously ineffective and has been willing to adopt much of the machinery of market-driven economies; yet, it has not completely disavowed its recent Communist ideological roots.  Without experiencing a complete train wreck, it is hard to imagine China not increasing in economic and political importance.  The mere virtuous impact of positive compounding from a low base – a country with a large population of seemingly avid consumers and a political thrust moving to satisfy/mollify this massive constituent base – virtually guarantees a mushrooming balance sheet and its accompanying benefits and woes.

As the world’s second largest exporter of credit (after Japan) and growing, China’s Treasury and economic policies hold tremendous importance around the globe.  A decision to limit, maintain or increase U.S. Treasury holdings, impacts both China’s economy, that of the U.S. and of those countries with currencies pegged to the $U.S. or inextricably economically linked.  As the world’s largest single exporting nation (the E.U. in aggregate is still slightly larger), where the RMB is set and the levels of interest rates are of high importance.  With exports running at more than 30% of GDP and a large remaining agricultural sector, China remains both economically and politically dependent on the health of its trading partners.  That China has achieved what it has is extraordinary, particularly coming from an atrophied, decayed and corrupt base, with a highly xenophobic past leadership.  Big problems remain in a corrupt political system, an unevolved banking/financial sector, an under-tested legal system and a still large protected group of SOE’s.  Commentators split on whether these deficiencies will cause major delays in China’s upward progression – personally, I see them more as a tropical depression than a full-fledged typhoon!

HOW THE CURRENT POLITICAL SYSTEM ACTUALLY WORKS

The first thing one needs to internalize is that China does not operate by the same rules as most developed nations.  The overarching reality is that democracy is neither a short nor longer-term goal within China.  The paradigm is completely different from those of the U.S. or even more socially democratic governments in Europe and elsewhere around the globe.  For China, the political system is merely the mechanism towards a defined set of goals that are set not by popular demand, but by the Select few at the top, through a byzantine and very secretive process (that may or may not be for the good of society and the country).  The benefits are that change is easier to enact – to the extent it is expedient to allow more popular input (as at present), so be it; when the converse is true, the power structure is designed to allow for dramatic reversals.  The risks are that in the wrong hands, bad policy and bad decisions can be enforced without recourse.  The culture is different.  It is next to impossible even for local Chinese to effectively read the tealeaves.  There are rarely ‘winds of change’, more like subtle breezes that confound even local political meteorologists.  As a foreigner, particularly an American, interpreting a conversation can be very difficult, let alone understanding the overall context.  Spoken words are not intended to be taken as literal.  The American approach of ‘I say what I mean and I mean what I say’ is simply not part of the cultural paradigm – for better or for worse.  In fact, it is generally considered uncultured, uneducated and/or just plain rude to be direct. In Mandarin, the use of different tonal pronunciation of the same word, generates different meanings; and the language is a fine metaphor for the culture behind it.  Subtlety and circularity are inalienable parts of life in China.  Understanding cultural differences is paramount.  The Chinese culture embraces superstition, with numbers being lucky or unlucky; similarly, colors are very important symbols.  A complete understanding, as a foreigner, is rather problematic.  So where to start? First, understand how the political system is set up, at face value, and where power lies.  Although this is very complicated in most countries, it is even more so in China. Before explaining why, let me simply provide an outline, from the bottom up.

 

1. There are five levels of local government hierarchy (four official): (i) the village, not a sanctioned part of the system; (ii) the township; (iii) the county; (iv) the Prefecture or Municipality; and, (v) the Province.
2. At each of the four official levels, there are both elected officials and a member of the Communist Party who share the power.  Not only does the Communist Party official have precedence, most of the elected were carefully screened as candidates by the Party – after all, why leave anything to chance!  Needless to say, loyalty not merit is the key consideration.
3. In Autonomous Regions there is a symbolic show of sensitivity to the local ethnic group.  In reality, there is then an even more authoritative Party member.
4. There is a tiered system, with local officials elected directly by the populace to the People’s Council; the People’s Council then votes members onto the People’s Provincial Council and members of the Provincial Council vote for members of the National People’s Council that congregates annually in Beijing.
5. Responsibility for each key functional area is shared between an official at that level of government and his/her equivalent at the next higher level of government.  This is meant to act to provide a cogent hierarchy, an effective level of oversight (control) from the top and to limit the amount of ‘slippage.  In reality it can create more opportunities for subterfuge and certainly will often result in decreased efficiency in decision making and implementation.
6. In Beijing, power-central, the game becomes even more complicated.  Power is supposed to be shared among the President, The State Council (composed of Vice Premiers (4), State Councillors (5) (same status as VP’s), and 29 Ministers and Heads of Commissions and the supposedly supreme National People’s Congress.  Although no longer a pure rubber stamp, policy is generally conceptualized by the State Council under the leadership of the President.  And yet, because there has not been a ‘strong’ leader, there has ended up being a huge amount of ‘horse trading’, leading to ‘consensus’ policies rather than autocratic ones.  Ironically, the last strong leader was Deng who never officially occupied the top official positions.
7. And then there is the Communist Party, with its own structure and hierarchy.  The Party is led by the General Secretary, who is the most important person in China.  Next comes the Politburo, consisting of 22 members of which the Standing Committee of 7 is the most important.  Under them is the Central Committee of 205 members and 171 alternates.  Alongside is the Secretariat, responsible for the bureaucracy that is a fief of the General Secretary.  In order to assure Party control, the General Secretary is also the President.
8. The military is supposed to be jointly governed by the Central Military Commission of the State and of the Communist Party, but the CMC of the State is rigidly screened to make sure the right candidates are on board, thereby ensuring full Party control. The head of the military is also likely to be the President and General Secretary. The following chart from the U.S.- China Business Council from PRC government websites, doesn’t even show a State CMC.
9. There is a legal system that has been evolving since 1980.   It is more developed on the criminal side than the civil, but is still in its early gestational period and its enforcement is uneven.  Although the headline is that, as it strengthens, its independence provides a counterbalance to existing power structures, the laws are essentially designed and changed by Party leaders and functionaries and, therefore, are more likely to further enhance Party influence.  Essentially, the Party is above the law and, therefore, if Party interests are at stake, the law is unlikely to be implemented.  This makes the odds of foreign companies prevailing against SOE’s rather low.(Click the chart to view via US China Business Council)

 

The system is essentially a ‘super-matrix’ that tries to balance/organize the following:

• Centralized power and regional control at different levels, with little cooperation among the provinces
• Bureaucracy and political function
• Communist Party and ‘secular’ power

As indicated above, it is insanely complicated to understand how the structure works in concept, let alone to trans- or circumnavigate it.  Things become wildly more difficult, when practical realities are brought to bear.  Even if the structure were sound in its overarching goals, China has a huge impediment to execution as a result of major and minor power struggles and ubiquitous corruption.  There has been an explicit policy and vigorous hand-wrenching over the problems of corruption, but tacitly it is accepted and in some ways even encouraged.  Exceptions like Bo Xilai are publicly excoriated and dealt with, but otherwise it remains the same old same old.  The new regime has made even stronger statements that have had the short-term impact of diminishing public displays of potentially illicit lavishness, but no skeptics really anticipate a major change – for all sorts of reasons outlined below.

Entrenchment is always problematic to extirpate, particularly when the benefits are most endemic to those charged with the task!  More importantly, I am of the opinion that corruption is one of the major longer-term insurance policies leaders in Beijing are using to retain control.  Throughout the Mao Dynasty, control was maintained through having an extraordinary information network on all citizens, through all sorts of means – neighborhood councils, spies, etc.  Aggregation and control of records of activities allowed for complete control.  It is hard to imagine the infrastructure for this system has disappeared completely – perhaps its function has simply changed!  Without inordinate cynicism, consider that Beijing has actively supported the creation of a well-designed criminal legal system, but has chosen not to apply consistently.  At the same time, the means of corruption have remained easily accessible to officials throughout the country; it is not hard to believe that detailed records have been kept of wealth accumulated by these officials and their families.  As such, under current laws, a virtual army of politicians and bureaucrats are actually known to be guilty of crimes and they are fully aware their activities have been monitored.  What better way to ensure compliance to the Party line!  To the extent they do not challenge doctrine from Beijing or become an inordinate embarrassment, they continue to enjoy privilege and wealth.  Were they to dissent, it is easy to bring them to trial and in a public fashion, without a kangaroo court, find them guilty of crimes they have actually committed (in this way China’s hold on power is far more subtle and sophisticated than the old-style Soviet approach still in fashion in Russia).  To eliminate the means for officials to tap into vast unofficial wealth would, in fact, entail eliminating a crucial tool in centralized control.

Given this premise, it is important to understand the four primary types of corruption in China. Using Wikipedia as a source, I will summarize:

1. Pure graft.  This is the most bare-knuckled form and manifests itself in direct bribery, illicit kickbacks, embezzlement and pure theft of public funds.
2. Rent seeking.  This involves using monopolistic power to directly sell or receive ancillary benefits from providing use of some of these powers to commercial users (e.g. real estate developers being awarded government contracts or receiving public lands at below-market prices).
3. Prebendalism.  Using the power of one’s office to gain special privileges, benefits, deals, etc.  This area has been so prevalent, that until recently, there was an almost acceptable ‘price list’ to have a meeting with a public official.  Depending on the rank, the level of gift varied; for example, meeting with a junior official might require a bottle of Lafite Rothschild, whereas a session with a more senior official could entail a Rolex watch or a Louis Vuitton handbag for his wife.  This can escalate into foreign travel junkets for officials and their families and extend into paid education for children at home or abroad.
4. Misallocation of public funds.  Many officials use the public coffers as a means to live a lavish lifestyle (houses, banquets, staff, etc.) on the government’s budget.

As you can see, these broad categories permeate every part of daily life and particularly the effective execution of business.  It would be easy to go bankrupt simply greasing the palms of all those who might be useful or who pretend they might be useful.  The problem lies on a range of different fronts:

1. It is illegal for corporations based in the U.S. or with listings in the U.S. and those based in many other countries to pay bribes, although the line between a nice meal and one with a 1961 Lafite is often hard to define.
2. Enforcement by the U.S. and other countries has stepped up dramatically.
3. It is illegal under Chinese law to pay bribes in China.
4. To the extent you are comfortable sweeping laws and morals under the carpet, it is often difficult to understand which bribes are going to be useful.
5. As a foreigner, the risk is always high that a bribe not only doesn’t work, but might even backfire and be used against you!

Understanding how to navigate the Chinese society, business mores and political corridors is possibly the most complicated and important factor in engaging successfully on any front in China. The level of gamesmanship is simply much higher in China than it would be in most other countries.  You are safest to assume you are always playing a multi-dimensional chess game, spotting your opponent a rook, a knight and a bishop; remember, just because you aren’t paranoid, doesn’t mean they aren’t out to get you.  As such, a major problem is rarely even being aware of what you don’t know.  It is almost critical to have a ‘guide’ to help find a reasonable path; but how do you determine whom to trust?  And if you do find the right partner or advisor, the risks still remain high. Even the best laid out plans are much more subject, in China, to unknown, indeterminable tail risks.  The bottom line, is the bottom line must be sufficiently attractive to compensate for the panoply of incremental risks.  So, given the clearly uneven playing field, political quagmire, cultural differences and un-measurable risks, how can one improve one’s odds of success?  First, please understand that as in any gambling endeavour, there are few guarantees.  The question is often asked whether the risks are the same for large multi-nationals as for more modest entrepreneurs and those in between.  In some ways the larger you are the more you can gloss over, sweep under the carpet or simply power through; however, as BP learned in Russia, the bigger you are the harder you fall.  An unenforced legal system has the risk of hurting anyone.

As such, here are a few practical steps you might consider:

1. Truly understand as much about China as you can before you start.  Remember Shanghai and Beijing are not China, the same way that New York is not the U.S.  You must explore outside your comfort zone to figure out whether you and your organization have the stomach to operate sustainably in the country.
2. Determine who from your company wants to be in charge of the project or business.   Does he/she like China and the Chinese and be willing to live in China – if so, where?  Will the family move over?  Are they well suited to the lifestyle? Unhappy team members are less likely to have the appropriate focus.
3. As a corollary, understand which employees will be able to best understand the subtleties of the culture and system, while not succumbing to its temptations.
4. Determine whether there are global legal, accounting or consulting firms (that fit into your budget) who have had significant failures and successes in China who can help you from having to reinvent the wheel.
5. Understand that trust is a very ‘flexible’ concept and (as discussed earlier) the foundations of ethics stem from different sources and are applied differently.  Always start suspicious, but do so without being aggressive or showing your hand.  Build trust over time, but remember, it will rarely be safe to lower your guard.
6. Having said this, spend considerable time and effort upfront to research and find someone you believe you trust more, who has experience in your business/project area, who is local, speaks the language in the local dialect and is aware of the political landscape.  Finding a local JV partner might be more effective for achieving short-term progress and goals, but comes with the inevitability that over time goals and implementation methods might diverge greatly and when they do, you are unlikely to have the upper hand.
7. With your local advisor, figure out those in power who can help/hinder your project and who might gain/lose from seeing it succeed.
8. If you have local operating or financial partners, find out how well connected they are.  Understanding who they are and how they have done business is crucial.  Take no representation at face value – verify, verify, verify.  To the extent their ‘references’ do check out, to the best of your knowledge – do these represent incremental safety to you (i.e. will they be able to shield your business from outside interference and/or be able to access favorable treatment)? Conversely, will their relationships protect them in the event of some dispute?
9. Determine whether or not it is feasible, given legal and moral constraints to attract the right support and/or deter those antipathetic to your endeavour.
10. Figure out who your current competition is and who might enter the fray over time; most importantly, determine who might ‘support’ them and how strong they might be.
11. Determine whether, if you are successful, you are likely to become overly desirable and if so, who are the likely players to enter the game, whether they might have an unfair advantage and what you might do to block them or make them part of your team.
12. If you have proprietary Intellectual Property or advantageous process or branding, understand whether you will be able to protect them, both from your enemies and your ‘friends’.  Do everything you can up-front, such as re-registering all key company and product names in China, including all possibly closely related Chinese names.
13. If a major capital investment is required, can you finance it locally (on advantageous  terms) so that both your assets and liabilities are within China?  This might partially level the playing field.
14. If your investment requires the acquisition of real property, determine to the best of your knowledge whether you have clear title, and even if you do, what you can do to protect yourself against eminent domain or the simple private rapacity of those in positions of power.  Although this is unlikely to happen explicitly at the highest echelons in the capital, the local fiefs around the country can get away with untold amounts.
15. Will you have control of or access to the full accounting and cash flow chain?  The probability of monies finding unexpected homes, increases dramatically the further you sit from the cash register – and China is quite distant from the seats of most Western companies.  Conversely, the closer you sit, the less protection you have if some of those funds need to be paid for ‘unconventional consulting’ services.
16. Carefully evaluate how you look to repatriate cash flow streams.  Getting funds out of China can be problematic.  Although this has eased to some degree, one does remain at the mercy of the current regime – either bluntly in terms of interdictions, or more subtly (as occurs around the world) in the form of taxation, fees and currency regulation.
17. If you intend to keep monies local, carefully understand the implications of not hedging the currency and the costs of doing so.
18. Carefully establish exit strategies up front and constantly review whether or not they remain feasible.
19. Never take anything at face value or for granted.  It is not that opportunities are not plentiful, merely they will often have unanticipated facets that might complicate your life.

OVERALL CONCLUSIONS

There are no easy conclusions to draw.  China is just entering a new ten-year leadership process and the dust behind the scenes is far from settling.  As discussed above, the level of politics is extraordinarily high – apparently making the Vatican seem like child’s play!  The stakes are vertiginous, both for the country and personally for the individuals who have/gain/lose control.  It will take at least a couple of years for an effective transition to take place and even longer for anyone to have a good shot at interpreting the tealeaves.  As such, this piece has not tried to predict political action, more to reflect on the political and practical realities facing China and those interacting with the country.

The distance covered in a mere three decades is almost beyond comprehension.   The level of change has been enormous and continues apace.  However, the acceleration (the second derivative) that has been achieved is difficult to see continuing.  This does not mean there will not be massive change and progress going forward, it just means that one cannot extrapolate past results in a formulaic way into the future.  It is much easier to achieve 100% growth on a small denominator; as the base grows, achieving similar future growth becomes challenging at best – please refer to Apple Computers!   The question as to whether China will become the world’s dominant super-power is one well worth contemplating.  That this is a foregone conclusion is far from certain.  That the country has achieved a three-decade period of enormous success and progress is undeniable.  Watching China become a power player on the global stage is one thing – seeing it take the mantle of leadership is another.  With its population base and growing wealth, it is positioned well to benefit from a virtuous cycle – growth creates more wealth that is then recycled back into the economy or into productive international investments, that then cause further growth, allowing for more infrastructure, educational, healthcare growth, and so on.  Knowing how to use these to maintain internal stability, evolve the political, economic and social system and take power away from the entrenched developed nations requires a different set of skills and resolve.

To date, China has had the blessing of not being ‘encumbered’ by democracy.  No matter how cumbersome it might have been to achieve a consensus among the power elite, there has not been the concern of voter approval or true judicial oversight.  Decisions have been and continue to be made and implemented, for better or worse with remarkable speed relative to other countries such as India or even the U.S. or Europe.  When things work well and the ‘talent’ is good, that is hugely beneficial; unfortunately, the laws of regression to the mean apply in China as much as anywhere else and the risks of largely unbridled power can lead to very bad results as well.  For China to be a welcomed and sustainable super-power (i.e. one not forced upon the scene by military might), it has the following challenges it needs to overcome:

1. A judicial system that is perceived to be, and actually is, applied relatively fairly and evenly across all constituents, whether they be rich or poor, politically connected or not, Chinese or foreign.  In the short-run, China has been able to skirt around the edges; over time, however, investors, institutions, employers, employees all need to feel they understand the rules of the game and that they have a fair chance of being protected and winning.  Without that, the cost of investment will increase over time, lowering profitability, decreasing employment and the concomitant tax revenue and slowing growth.
2. A liquid, diversified and well designed financial system. There need to be more sources of access to capital, both debt and equity and a system that protects all three constituents, owners, borrowers and lenders. Although the banking system has come a long way, it is still largely an arm of the Central Committee, without sufficient independence to assure smooth, uninterrupted functionality.  A public debt market, equity markets with depth, breadth and liquidity, derivatives markets to allow for hedging are all necessary to allow for necessary flows of capital.  Otherwise, there always looms the risk of lack of liquidity and the prospect of hugely inefficient and/or unwise allocations of resource.
3. A system where access and success are not predicated virtually entirely on Guangxi.  All countries have both explicit and implicit corruption (i.e. direct bribes and use of connections and influence).  Unfortunately, it seems to be an inextricable part of human nature.  In many countries, particularly developing ones, it is ubiquitous.  Often it is a functional part of the system – the country has insufficient tax revenues to pay for all governmental and police functions, and therefore pays its civil servants a fraction of what they need to survive (let alone thrive), expecting the rest to be ‘made up’ in whatever ways are most expedient.  Although generally undesirable, it is understandable in countries emerging from dire circumstances; for a country looking to be at the top of the food chain, it must be eliminated.  However, for reasons discussed earlier, one of the major strategies for maintaining centralized power is a controlled dissemination of ‘privileges’, primarily the illicit aggregation of family wealth, by those needed to run key federal and local aspects of the country.  Furthermore, 5,000 years of history are hard to change overnight.  As such, it would be disingenuous to anticipate a major actual near-term shift in this area.
4. A government that is not a question wrapped in a riddle packaged in an enigma.  The use of stealth strategy, whether that is on the military, business or policy front can be very effective in the short run.  However, over time, alliances based on real factual interchange and genuine serving of mutual interests becomes necessary.  China’s continued use of ‘Oz’ behind the curtain and trade policies that are allowed to proceed only to pander to the basest level of consumer capitalism are, realistically, not sustainable.  Unfortunately, given the opacity at every level of government, short-term change is also unlikely.
5. A social structure that does not consistently feel it is teetering on the edge of morphing into something different, yet something that no one can anticipate.  The U.S. ideal that China will wake up one day and suddenly agree that Western democracy is the divine preordained solution is both unrealistic and fundamentally flawed.  China has a unique history and its ideal social paradigm  for today has yet to evolve.  However, as with the prior point, the obscurity in which major national decisions are made, creates a constant level of uncertainty, that is designed to keep any ‘opposition’ off balance, but which in fact has the long-term effect of destabilizing society.  Unless Beijing chooses to revert to blatant nationwide military suppression of its population, there is a clear need to signal the pathway that has been chosen and then to implement it.  The Chinese look more to results than anything else.  These do not need to be democratically achieved, merely well developed, communicated and executed.
6. A plan for how China’s growing military force will interact with the rest of the world.  Although not the major concern of the U.S. and Europe to this point, China’s growing technological prowess and its means to support a vast standing military, is become one of the key geopolitical quandaries.  There are many reasons to try to avoid Cold War types of battle lines, yet without meaningful and clear communication, the other current world powers will be left with little choice than to circle the wagons.
7. An internal policy on resource distribution, education and social services that allows calm to prevail.  The recent history of virtually total penury among most of the vast population remains vivid and alive.  The maintaining of internal stability is key to any growth strategy; this, however, is easier said than done.  It seems inevitable there will be lurches forward accompanied by frequent backsliding.  The economics and politics surrounding these issues is enormous and will often lead to contentious and intractable situations.  The increase in types and amount of media and non-government sanctioned communication/propaganda is enormous, and will make the unopposed implementation of policy virtually  impossible.
8. A policy for economic balance that is not subject to the vicissitudes of the economies of major trading partners.  China is a potentially large enough economy to allow for a huge percentage of GDP to depend on domestic consumption.  Getting to that point is extremely important, as the problems in the rest of the world are likely to lead to unpleasant periods of brinksmanship that, frankly, neither side can afford.  China needs to refine its internal economic model sufficiently to protect itself, to a large extent, from external contagion.  It is difficult, however, as consumption will be constrained by a high savings rate needed by individuals to compensate for no pension system or reliable healthcare.

Each of these points can be achieved to some extent; yet, none is easy, particularly in the short-term.  Those who see the imminent demise of the current global status quo, dominated by current powers, are most likely plain wrong!  That the balance of power is undergoing tectonic shifts is undeniable; however, the vast amount of amassed wealth and power of long-established (colonial) powers, will not evaporate overnight.  It is important to understand both that those with an advantage will not cede without a struggle and that those trying to squeeze a century of development into three decades will not do so without interim setbacks, no matter how careful the thought and how punctilious the implementation.

The fact there remains so much uncertainty around China is part of the opportunity.  There are certainly obvious areas of potential and, ironically, each area of major risk probably affords even more opportunities.  The fact that China is large and growing and that it is moving from poor agrarian to sufficiently affluent urban is undeniable.  This represents significant opportunity in every type of deliverable – housing, transportation, clothing, food, entertainment, travel, etc.  However, as most of you reading this letter were not reared in the PRC during the Cultural Revolution, it is important to be particularly prudent in how you seek to take advantage of opportunities.  China needs ongoing sources of outside capital and expertise and will promise whatever is necessary to entice them.  The reality, however, is that China remains a State-tolerated ‘kleptocracy’ and the operative approach needs to be ‘caveat emptor/investor’!  The legal system is there, but not necessarily there to protect the outsider, or even the local who does not have the right lineage or connections.  Large discounts need also to be applied to any set of returns, given the potential for financial market manipulations and potential changes in liquidity, both regarding extracting capital from the country and also exchange rates.  In China, a prudent investor must focus first on return OF capital, long before return ON capital.  The new leadership has begun to signal very strongly that the policy of relative acceptance of both quotidian and massive scale corruption will end, but given the level of entrenchment and the benefits to those trying to retain power, it is hard to believe meaningful change will occur at any time soon.

(Edited version of a letter written in May, 2011.

It has remained a problematic environment since May 2011 for traditional mean reversion strategies.  The winning solution has been to time the markets and be in for the ride – long equities, short commodities, long mortgages, etc.  The issues in this letter remain largely the same today.)

The world is still trying to work out whether everything is okay.  On one day Greece’s travails are magnified onto the world’s stage – the next a mollifying statement from Merkel defuses the situation.  Good quarterly earnings pump up the market; bad jobs data deflate it. Chinese prospects create optimism; municipal crises elicit fear.  The U.S. deficit weakens the dollar; the Japanese nuclear disaster strengthens the yen.

Global geopolitics and the evolution of the financial system remain topics of keen interest and discussion and even action – although no decisive or well-balanced action. As such, investors still remain subject more to macro impact than to true fundamentals. Nonetheless, it has not been a great environment for making money.  Interest rates are low and many early gains have been eroded or lost.  Everyone is trying to work out how to improve their portfolio performance; and yet, the fears of rising interest rates and equity market setbacks make investment decisions very difficult.

We have seen an almost unprecedented quest for ‘beta alpha’ – the value created by effective shifting among sectors and varying gross and net exposures.  This is all well and good, but in less sophisticated times, this was called ‘market timing,’ an endeavor sought by many yet achieved by few.  Hedge funds are seen as a primary source of beta-alpha, yet at Cadogan, we continue to believe the greatest value from the hedge fund sector as a whole is the efficient capture of mean reversion through superior research, rather than merely timing.  As is the case with sectors, styles also have cycles – the timing, however, is hard to predict.

In this letter we will revisit the perennial issue of what is the optimal scale for a hedge fund (and FoHF).  In doing so, we will undoubtedly restate many of the traditional arguments.  The reason for doing this is not to pass on thrilling new insights; rather, it is to bring back to the fore a key debate, where one side appears to be gaining a huge surge in popularity without a concomitant shift in fundamentals.

Traditional benefits of greater AUM

 There is little doubt that size brings with it a number of advantages

–                Perception of safety/stability.  Investors, like consumers, like individuals in general gain tremendous comfort from being involved in something that many others also endorse.  The belief that collective wisdom is composed of the sum of individual insight is widely held and is often accurate.  On the other hand it can also be the cause of bubbles, and abrupt shifts in markets, when facts become evident to the majority long after they have been clear to the few.  The generation of alpha is most frequently a result of either superior or more timely analysis and implementation by the few!

–                Ability to hire broader/deeper team.  More revenue, allows for more expenses.  Many of the larger funds have reached their size based on track record or visibility of their principals; this creates a cachet that often makes attracting top level players somewhat easier.

–                Ability to spend on outside research services.  A greater budget allows one to use outside resources that smaller funds might not be able to afford or might use ‘soft dollars’ to pay for.

–                Ability to ‘move’ prices. Although this will not be readily admitted by many, larger funds can often move the price of securities they are invested in.  This can often lead to improved performance numbers over a period of time, particularly during strong bull or momentum-driven markets.

–                Bully pulpit. Larger funds are able to make larger investments and potentially have more impact on their own destiny by taking either control or utilizing significant influence.  If well used, this can help improve the value of positions invested in.

–                Better ‘calls’ from research desks.  Although it may be hard to believe, if you pay more in commissions, you might get better access to information. Historically, this has been a very relevant factor.  In an environment of increased regulatory scrutiny, particularly vis-à-vis insider trading and research practices, it will be interesting to see how this evolves.  It would be hard to imagine, however, that a group paying $10mm in commissions will not get better ‘service’ than one paying $50k!

–                Flexibility on diversification. A larger fund has a better ability to move in and out of sectors/areas as their level of interest changes.  Having different teams that one can support, even if there is little current activity is a potentially big advantage.

Traditional benefits of lower AUM

–                Focus.  Many specialist funds are almost by definition smaller.  To get direct exposure to a particular area of expertise (e.g. biotechnology, microcap, trade claims, weather derivatives, etc.), the best access is often through a specialized hedge fund manager.  Many of these are either smaller by design (because the specialty has more limited liquidity) or because of their stage of evolution.  In either case, it can be an interesting opportunity for investors.

–                Ability to invest in off-the-run securities. With ever-improving quality and speed of information flow, the efficiency of pricing in better ‘covered’ securities constantly improves.  Betting against the flow can make money, but over time creating sufficient alpha to counteract the fee loads can be very difficult.  Finding differentiated information on more obscure companies and/or classes of security can lead to sustainable alpha.

–                Nimbleness, easier to build and get out of positions.  Being able to operate in less well-trafficked names, by definition, means lower liquidity; smaller funds can move much more easily in and out of such less liquid names.

–                Access to top talent.  As much as there is a desire to categorize investing as a science, it remains truly an art.  The great longer term track records are most often obtained by those who can not only apply a consistent methodology, but who also have the feel of when to press or lighten their exposures.  Unfortunately, there are very few truly gifted investors.  Many of these are great at investing but less good at corralling the thoughts/efforts of others or running/growing organizations.  The advantage of some of the smaller, more focused shops is the access to talent that is not being attenuated by too many non-investment-related responsibilities.

–                Better alignment of interests.  When a manager is hungry, he/she is often more focused on achieving results. When the incentive fee is the primary source of reward, rather than the management fee, there is generally much better alignment, assuming one has done sufficient due diligence to fully understand and agree with the manager’s risk taking proclivities.

–                Flexibility on terms/willingness to work with investors.  Hedge funds operate at the epicenter of the world of supply and demand.  When demand is high, which is certainly the current case for larger hedge funds and FoHFs, there is little immediate incentive to be flexible to the needs of most specific investors.  Obviously, this is not always the case and many larger managers balance short-term versus long-term benefits, but in most instances, smaller managers with a desire to fill more unused capacity and build a better margin of safety, are willing to work more closely with investors to find solutions that are more ‘balanced.’  Needless to say each basis point less in fees paid is a basis point more of alpha!

–                Better long-term ability to generate alpha.  This is a summary of all of the categories discussed above.  It remains controversial, with academic studies still coming out on both sides (more on the side of small over big), but the rigor and validity of the results are subject to imperfect data, short time streams, etc.  In summary, the facts are insufficient to outweigh instinct.

How does the current environment impact this debate?

Naturally, there is no pre-defined set of solutions for an appropriate structure and one of the defining variables is the environment in which one operates. As such, we would like to look at how the current environment impacts the organizational needs of hedge funds and FoHFs.

–                Macro Driven.  For most of the past three years, the dispersion in return among securities within sectors and even among sectors has been low (to extremely low).  This has made bottom-up research less valuable, whether this is long-only value or any form of mean reversion capturing hedge fund.  Outsized returns have generally been achieved by those focusing on macro variables and successfully choosing the appropriate directionality (recovering debt markets, surging equities, increasing commodity prices, weakening dollar, etc.),  In this environment there is little benefit to smaller funds – not necessarily any disadvantages – although many argue considerable heft allows for better access to sensitive political information or sophisticated trading systems increase the predictability of flows.

–                Unstable financial system.  The fact that the financial system has not yet been ‘solved,’ brings risks to all investors, not just to hedge funds.  However, the greatest risks are on the access to and terms of leverage, the reliance on OTC securities, the terms of ISDA agreements, the access to and terms of shorts, the custody and rehypothecation terms, etc.  Although these impact most strategies, they are particularly important to more complex and highly leverage ones.  In this environment, the ability to fully understand all terms and negotiate is very important.  Larger funds are more likely to be able to make inroads in negotiations.  As such, except for basic strategies, there is a current advantage to larger funds.

–                Increased regulation.  Whether it is Dodd Frank, changes in E.U. regulation, the impending Solvency 2 or Basel 3 or changes in pension fund regulation, it is clear the trend is that more regulation is on its way, not less.  Most of it will be well-intention, but likely to be badly conceived and executed.  This will mean that investment managers will have to be both careful in their adherence to changing rules and reporting requirements and potentially clever in finding opportunities emanating from the changes.  We believe the compliance burden will go up, requiring most hedge funds to dedicate more resources to the area – thereby raising costs; however, the incremental cost, in most cases, is likely to involve some outside legal advice and the hiring of one professional (or maybe even less than one full-time employee) and, therefore, only to be onerous to very small funds.

–                Increased institutionalization.  As institutions find their traditional investment options less and less appealing, more and more seek out alternatives.  Hedge funds represent the most accessible liquid alternatives and have been attracting more and more interest.  The lack of transparency, more onerous terms, higher fees, etc. have represented obstacles, but the pace of increased interest continues to grow.  We do not see this as abating.  To date, and for the near to medium term, this will be strongly to the advantage of larger funds.  Over time, as investors become more familiar with the area and have a clearer understanding of the alpha generation engines, the focus is likely to broaden out to encompass less ‘attractive’ (i.e. traditional institutional) structures, with better investment returns.

–                Low interest rates.  There is a need today for income and return.  When nominal interest rates are low, this eliminates a large source of income for many investors (whether individual or institutional); this changes the risk profile investors are willing to take. With the volatility associated with higher potential return strategies, there has been an understandable move to hedge funds.  The goal, in many cases, is not pure alpha generation, but more efficient capture of beta (i.e. some downside protection) and beta alpha (timing).  In our opinion adopting to low interest rates has little to do with the size of a hedge fund, and more to do with its strategy. For example, in this type of environment, short selling (and the short component of long/short investing) is more challenging, because there are no returns on cash or short rebates going to managers, thereby removing a key element of return from the strategy.

What is the minimum size necessary to be ‘institutional’ in quality?

Essentially, in most cases there are three separate metrics that need to be satisfied in ascertaining whether a hedge fund or FoHF is institutional.

–                The level of AUM.  There is no set amount, but many organizations don’t like being more than a certain percentage of a fund’s assets.  In most cases this now ranges from 10% to 20%.  To be attractive to most mid-sized or larger institutions, the fund must be able to accept an allocation of at least $50 million (often much more).  As such a fund that is less than $250 million is very unlikely to meet the criteria, while $500 million is more in  line with general expectations.  For larger allocations, naturally, there is a strong bias to much greater size.  The exception is in separately managed accounts, where a number of sophisticated investors look to take advantaged of the greater flexibility and/or expertise of a smaller manager while not feeling ‘trapped’ into a structure in which they might be too dominant.

–                The breadth and depth of staffing. For a hedge fund, the range can be quite large.  Even large institutions are often willing to accept a more constrained staff, as long as the strategy does not involve inordinate complexity.  For a long/short manager, the key is to have a distinctly superior quality of research/trading staff, a good back office/compliance function and an ability to meet client information demands (often significant). Generally, this would be hard to accomplish with fewer than seven staff.  Once again, the modal number is much larger and there are also exceptions on the low side.

For a FoHF, the trend has been towards larger managers, with extensive research staff that divides into ‘silos’ of expertise, complemented by portfolio managers for the different types of products.  This is supplemented by an independent Operational Due Diligence team and a quantitative risk team.  The back office needs controllers for the funds, appropriate legal, compliance, IT and general management.  And finally, to allow for a breadth of clients and increasing informational demands, a healthy client service and sales function.  Looking granularly, unless the FoHF is specialized and/or limited to a small number of underlying managers, it would appear that one would need an absolute minimum in research of four people (and then only if they are very experienced), one or two in ODD, one in Risk Management, two or three in control functions, one for legal and compliance, one for IT and three or four in client facing functions.  This totals about 15.  Most capital, however, is flowing to funds with considerably more staffing, as there is a perception of safety in numbers.  This leads to the last criterion for size.

–           Perception.      Larger numbers of staff are deemed to signify stronger processes, procedures and control – all important issues in today’s world of greater transparency and public scrutiny.  Although there were large firms that became mired in Madoff and other problem funds and small firms that avoided them all, there is an increased belief that the risk to the institution is lower if there is an appropriate ‘optic’ and a stable of large co-investors.  The old adage of ‘no one can be fired for buying an IBM’ has certainly evolved into the FoHF domain.  And, there are good reasons that firms grow and attract a growing level of support – performance, avoidance of blow-ups, strong presentation/client skills, etc.  However, the problem in the liquid alpha space, is that in many cases finding liquid alpha is not an institutional process – it is much more art than science and can be very entrepreneurial in nature.  Many of those best at doing so, are not the best as presenting to Boards and absolutely cannot define the process in a way that is reproducible by others. The risk control process in many cases involves understanding the underlying strategies and securities exceptionally well and deliberately underweighting or overweighting positions in complete contradiction to risk models.  The understanding of managers, strategies and risks is often found most in those who prefer to focus on these areas and who, frequently, are not good managers of teams and of people.

In the alpha game, becoming part of the pack is, axiomatically, self-defeating.  As we have often said “Alpha is where other people are not.”   Although some process and procedure is necessary, the full ‘institutional package’ is probably better targeted towards beta strategies.  The idea of endorsing and embodying style drift and tracking error is one that is often fundamentally at odds with an institutional ideal and is a clear reason why most institutions have avoided hedge funds.  As more begin to invest, the strong temptation is to concede to all their perceived needs, even those that detract from performance. Trying to fit a size 12 foot into a size 10 shoe generally leads to pain; we are concerned that the hedge fund ‘industry’s desire to meet the new institutional requests will, over time, lead to a severe degradation in alpha generation.  In a market, where most returns are beta-driven and where timing is the key differentiating factor (such as the one we have experience over the past three years), this might well be masked.  However, over time, the generation of alpha will continue to be best executed by a small group of obsessive, focused, visionary idiosyncrats.  The most important job of a great fund of funds will be to find and harness this talent, not to go with the biggest players with the longest track records and most institutional processes.

 

Edited Version of Letter written in December 2011

Although, in many ways much has happened since the end of 2011, in reality few of the issues outlined here have actually been resolved. In spite of this, the equity markets have soared and the fixed income ones have yet to need to correct. Pension funds and investors have been able to enjoy strong returns that helps their level of funding, but the degree of fear remains quite high. I have changed none of the original commentary.

 

THE WORLD

We know it must come as a complete shock to all our readers that there are unresolved issues in the European Union and around the globe.   The wild swings of pessimism, followed by powerful relief rallies, based on little more than short-term expedients continue to make this an extraordinarily tricky environment for virtually all investors.  What is likely to create a meaningful paradigmatic shift at this point in time?  Unfortunately, we see nothing on the horizon; politics and economic influence on politics are likely to drive the status quo among power brokers leading to a period of continued uncertainty.  In the past military intervention has been the most common outcome of severe economic shifts or major shifts in balances of power; however, in an era of greatly changed military capability and much more diffuse and broad-based forms of communication, historic patterns are not necessarily great predictors.  In order to evaluate the situation, though, it is necessary to understand underlying fundamentals.

The problems.  Boiling everything down, the biggest global issue is that developed nations – Europe, U.S.A., Japan, Australia, etc. – as nations, have developed a sense of entitlement and have passed on a series of entitlements to a broad range of their citizens in the forms of benefits (retirement, health care, services, etc.) that might or might not have been reasonable at the time of granting, but today are becoming increasingly less sustainable.  The severity of the problem has increased dramatically, the longer it has been swept under the carpet.  Whether that is the increasing budget deficits or unrealistic pension (social security or private) structures in the U.S., the demographic nightmares of Japan and larger swathes of Europe and the concomitant social programs widely available in these social democracies.  In a nutshell, these are either currently not affordable (as in Greece and similarly stressed economies) or not sustainable in most other developed nations that are becoming more and more dependent on effective ‘subsidies’ from developing nations such as the BRIC nations.  Hardly surprising, it is much more difficult to get individuals to accept cutbacks than to take on cheap loans and increase material standard of living.  Discontent is in the air around the world, as Wall Street, Boston, San Francisco and even Detroit are ‘occupied’, students (and others) storm through the City and other parts of the U.K. and pre-riots occur around the Continent.  Yet, an equilibrium needs to be established.  Either privileges need to be revoked, inflation allowed to devalue the accumulating debt (and individuals’ wealth) or taxes increased sufficiently to afford the current high levels of spending.  We ignore the obvious increasing the efficiency of programs – something surprisingly resistant to any form of applicable change!

Who is currently the tallest midget?  Europe is not a candidate.  It remains in the spotlight as the most obviously dysfunctional and conflicted geographic region, with a fundamentally challenged currency structure highlighted by massive cultural, economic, tax and productivity differences across the continent.  Yet, Japan’s insistence on an ostrich-like approach to ignoring the issue does not place it much further up the ladder. The U.K., Canada and Australia have their own issues and Switzerland and Norway are simply too small to have major global impact.  That leaves the U.S. as the most likely destination of ‘flight to safety’ capital, in spite of a large and growing set of deficits and a political system that is controlled by interest groups that fund the political process, and are rife with self-interest that can prevent the types of solutions that a free market economy would advocate.  None of this makes us feel sanguine about the future.  Yet, as 2008 has clearly demonstrated, there is a sufficient existing ‘reservoir’ that even crises are unlikely to cause an immediate collapse.  We have experienced muddling through, but with a mounting severity, it is uncertain just how long this laissez-faire attitude can continue.

Above and beyond the national and regional struggles there remain the large unsolved issues surrounding the global financial system.  This remains in need of a revision that unfortunately seems unlikely to happen in the foreseeable future.  The desire to regulate is laudable but unrealistic even in individual countries, let alone across national borders.  Without a concerted effort to arrive at a holistic global situation, there is no way to significantly improve the banking, insurance and other overlapping financial sectors. And with apparently insurmountable internecine strife among regulatory bodies within specific regions, it is hard to imagine a solution brokered across borders.  With unclear mandates as to their respective functions, banks and other financial institutions blend providing services with risk taking in ways that are unclear, with mandates that are equally lacking in precision.

The solutions.  There are no clear multi-faceted solutions to our current financial mess.  We have little confidence in top-down solutions, given an apparently intractable and labyrinthine political landscape.  As unpopular and improbable as this might sound, it will be financial institutions themselves, pressured by their investors, debt holders and clients that will need to articulate and implement clear solutions.  These will entail establishing appropriate balances among risk taking and service providing, setting appropriate balance sheet parameters, particularly vis-à-vis leverage, and forcing the implementation of employee compensation systems that reflect a longer time frame and better align employees with those having balance sheet interests.  Although reticence will most likely be the modal ‘first response’, we see progress along these lines as fairly inevitable.

Impact on hedge fund investing.  Over any meaningful period of time, uncertainty generally benefits hedge funds operating on mean reversion.  A more in-depth understanding of balance sheets, companies and industries can allow for positions to be taken with greater certainty, often against the tide.  This can also create disproportionate upside. However, in the shorter run, it remains a difficult environment.  Low interest rates continue to put pressure on short selling and random volatility from macro events continues to whipsaw many managers attempting to control risk.  The lack of clear governmental leadership and direction makes many global macro and CTA strategies tricky as well.  The

current low level of corporate defaults tends to limit new distressed opportunities.  Low spreads on plain vanilla deals and reduced activity in M&A generally limit interest in risk arbitrage and many event strategies.  We believe investors should be looking at hedge funds in the short run more in terms of risk mitigation than upside capture.

Future of hedge fund industry.  In a low interest rate, lower return environment, it is hard to see how the current structure of hedge funds can be sustained. Historically while at Cadogan, I tried to lead the charge in attempting to affect fundamental changes in how fees are charged and how hedge funds are structured and run. I hope going forward there will be those willing to take the time and effort to sustain these efforts. I think it will be a win/win situation. With major financial institutions needing to limit their risk-taking functions, independent investment firms should be in a strong position to gain market share in many investment strategies. Institutions looking to access differentiated return and risk streams are likely to continue deploying capital into alpha-oriented strategies. However, there is increasing knowledge and sophistication in the buyer market and the value proposition will need to be more clearly defined.

This is particularly true in the intermediary market, where FoHF’s and consultants must justify the fees they charge.  We anticipate the big will get bigger for some period of time, but remain confident the real future of the intermediary market institutionally (and probably in the HNW market as well) will be in providing niche and differentiated solutions.

(Slightly edited letter from January 2011.  Nothing much has changed in the analysis.  From a practical perspective, however, there have been large outflows from many FoHF’s and many of the remaining have either decreased their fees or become considerably more tactical.)

The Future of Funds of Hedge Fund

Let us start with the basic premise that in this large world there is a vast array of investors and an enormous demand for financial products of all types. Obviously, no solution set satisfies everyone.  Under this umbrella statement, our conclusion is that FoHFs are, by definition, not appropriate for everyone; they can, however be very useful for certain types of investors.  This letter will look into how to prioritize one’s hedge fund needs and which means of access present the most efficient and effective pathways given those preferences.

Reasons Investors allocate to Hedge Funds.  Although this section might seem like a mere restatement of the obvious, we are often asked this question and, therefore, feel that setting down as many of the reasons we have been told by our broad range of contacts, might be useful.

• General Diversification. In a world where we are constantly reminded that exogenous risks cause virtually all financial products to correlate on the downside when liquidity disappears, the hope exists that hedge funds can provide some real diversification.  Given that many hedge funds often carry significant beta exposure, this will certainly not always be the case.  However, a carefully chosen portfolio, targeted specifically towards avoiding beta is highly likely to provide some protection in down markets – obviously foregoing some upside in major surges.

• Targeted Diversification.  There are many specialist hedge funds that focus on distinct areas (energy, commodities, futures, MBS, etc.).  Although in many of these domains there are a variety of traditional managers that offer product, the more unconstrained, sometimes aggressive approach of hedge funds can provide the most focused exposure.  In an overall market downturn, however, these types of funds are very likely to lose money.

• Capital Preservation.  In a world where fixed income has had a major run-up and spreads are very tight on an historic basis, and where equity volatility has been extremely unpredictable, there is a premium on finding ways to preserve capital in potentially turbulent future times.  Hedge funds are seen as a means for achieving this.  As has been made clear over the past several cycles, ‘hedge funds’ are not a monolith, rather an encyclopedic collection of differing investment styles and approaches, among which there are subsets that have been very effective at preserving capital.
• Return Enhancement.  Many hedge funds can and do use leverage and/or are willing to be very concentrated and focused.  For investors desirous of greater exposure to a given area for a specified level of investment, there are hedge funds that certainly fit the bill.
•  Improved Efficiency of Returns.  Although no one can spend a Sharpe, MAR or Information ratio, their importance lies in the potential availability of principal at any given time.  For an investor who will hold as long as necessary, and is not subject to regulatory or other constraints, a compounded 10% return is functionally the same, whether the volatility has been 2% or 30%.  However, few such investors exist.  As such, attention to the shorter and medium-term risks associated with each basis point of return is, and should be, of major concern.  Over time, portfolios of hedge funds can certainly provide better risk-adjusted returns than many long-only investments.
• Low returns on cash and short-term fixed income.  Although not a great absolute reason for seeking out hedge funds, the lack of a better alternative (please excuse the pun) is a reasonable short to medium-term reason to look at the area.  Many organizations are being squeezed by not being able to find return on any of their lower risk allocations.  Looking at lower risk hedge fund portfolios can be a legitimate exercise; however, real memories of 2008 are fresh in the minds of many investors, where hedge funds dramatically underperformed expectations. If major tracking error is an unacceptable risk, this approach is probably inappropriate.  As always, the key is to understand the risks both of making and not making an investment and evaluating these in the context of one’s own specific situation.  Although an investment in a portfolio might not be optimal, if the risks of not meeting cash obligations through lack of current portfolio returns have even worse implications…
• It was recommended by a consultant.  This is not a reason, in and of itself to invest.  Consultants are generally engaged to evaluate some combination of their clients’ investment policies, allocations and specific investments.  A recommendation by a consultant to look at hedge funds normally results from a considered allocation policy.  However, the responsibility remains with the investor to understand and agree with the investments being proposed.  Hedge funds are not necessarily complex, but they can be; we always recommend that investors take sufficient time to understand the risk trade-offs being made when moving into the area, so as to avoid unrealistic expectations, particularly in terms of left tail risks.
• It was requested/directed by the Investment Committee/Board.  Many Boards have one or more sophisticated financial professionals as members, who see hedge funds as addressing one or more of the potential benefits discussed above.  To the extent there is a distinct investment team, we believe it is important, as in taking on consultants’ advice, for those responsible for the day-to-day running of the portfolios to fully understand and agree with an investment.
• Competitors do it.  Although this might sound like a trivial reason, often it is not.  A great deal of investment information is now easily accessible to the public and has legitimately been available to concerned constituents.  Given the ‘fishbowl’ aspect to running much institutional capital, there has become an even greater need to keep abreast of new investment approaches than previously.  Obviously competitive performance statistics have long been important; today, however, there is far more granularity.Greatest Risks.  Before considering how best to access hedge funds, it is important to consider the various types of risks associated with this type of investment. The type of approach can limit certain risks, but each approach comes with its own set of costs.
• Poor Risk-Adjusted Returns.  As with any investment, the greatest risk is not to generate a level of return (over a pre-determined time period) that compensates for the levels of risk taken.
• High Fees.  Anything that takes away from the gross performance increases the risk of not achieving the return bogies that are set.  Many hedge funds structurally cannot avoid higher fee levels, for reasons as simple as having a lower level of AUM combined with a need for top investment professionals; others charge high fees because their historic returns create sufficient demand to support them; many others rely on industry ‘norms’ that seem unjustifiable and we believe unsustainable as well.
• Insufficient Alpha for the Fees Charged.  Hedge funds need, first and foremost to generate returns.  However, the high fee levels charged should neither be for creating beta, nor for providing leverage; they should be primarily for alpha generation.  This aspect is often not sufficiently scrutinized by investors.
• Potential Strategy Complexity.  Although many hedge funds could not be simpler in what they do and how they execute (e.g. research companies and then either buy stock or sell it short), others can involve complexity in both conceptualization and execution. In these strategies, most investors need to rely on track record, reputation and other ‘soft’ aspects of due diligence;  the strategies might indeed provide a different type of diversification, but the topology of that diversification is very hard to map.  It therefore requires a certain type of risk tolerance to invest.
• Shifting Liquidity.  Many longer-term investors have historically been relatively insensitive to illiquidity; hence their allocations to real estate, private equity, infrastructure, etc.   Nonetheless, they have structured their overall portfolios to have allocations to meet interim cash needs.  For most investors, hedge funds have traditionally been categorized on the more liquid side of the spectrum.  As 2008 demonstrated, this definition, although perhaps correct most of the time, might not be valid during extreme market conditions – exactly the time when investors prize liquidity the most.  As much alpha remains ensconced in securities/situations that are smaller and/or potentially less liquid, taking a conservative approach in how to categorize them is probably most prudent.  Having said this, UCITS-type products, promising high liquidity, have begun to proliferate. Although many of these might legitimately be liquid, this will depend on the strategy.  The question then becomes one of being able to generate a sufficiently interesting return profile.
• Potentially Limited Transparency.  Most hedge funds do not provide full, unadulterated transparency – i.e. on-line views of all positions at any time.  The general range is from weekly full portfolio distribution all the way to ‘you’re lucky we provide you with quarterly return data!’  Although the latter sounds ridiculous, 15 years ago that was among the most common of responses.  Today, many funds have made considerable efforts to listen to the needs of their institutional investors.  However, many also remain concerned by open disclosure of positions to a broad range of investors, given the general sensitivity of shorting, the difficulties of growing control positions and the fluctuations in liquidity.  The presumption that all investors are discreet, 100% straightforward, etc. is probably naïve and can harm other investors in the fund.  Many managers are simply trying to balance the interests of all concerned.  On the other hand, there do remain those who refuse to disclose for no better reason than they don’t have to.  Transparency is important because institutional investors face the difficult decision of needing to find alpha investments, while facing ever-growing scrutiny from their Boards, constituents and regulators.
• Documentation and Legal Complexity.  Although life for all sides involved would be much easier with some form of standardized documentation, this is not on the cards in the near future.  This means, for each hedge fund investment, needing to review a broad range of documents and frequently negotiate side letters to gain certain rights can be arduous and normally requires a sophisticated legal department familiar with the specifics of the area.  Depending on the number of investments, this can be both a time consuming and personnel-intensive process.   During a time period like 2008, when many funds experienced difficulties and took a variety of ‘remedial’ actions, the level of focus necessary to protect one’s rights and obtain sufficient information can be particularly onerous.
• Regulatory implications.  Even prior to the market and financial services meltdown of 2008, banking, insurance and pension regulators around the world had started to reassess their definitions of risk, permitted activities, reserve requirements, etc.  The large losses suffered across many investment areas in 2008 heightened their concerns and also made the issue far more public and political.  Hedge funds as a group, although no real ‘grouping’ exists, are generally viewed as high risk, whether or not that is the case and the current winds would indicate that their treatment will not be favorable.  Naturally, there is some chance that rules will be written by the type of underlying investment, not merely by nomenclature or legal structure but, for the moment, institutions likely to be impacted are being very cautious in their investments into the area.

• Headline Risk.  With the greater transparency many institutions provide their constituents, the issue of headline risk has become even more important.  Although investment professionals understand risks are needed to generate return, this is not universally well-understood.  There is almost no losing investment that when scrutinized ‘ex post’ cannot be framed in a way that maximizes negative criticism.  When such an investment is in a household name like Citibank or General Motors, there is little push-back; however, if the losses – even if they are much smaller – are in hedge funds, the natural antipathy of the general public to the area makes headline risk a dangerous reality.  Naturally, the protracted Bernie Madoff saga highly exacerbated this concern.

Yet, in spite of all the risks, there is still a real need for sophisticated investors to generate return streams that provide some diversification from their traditional allocations and where the superior risk/reward characteristics add to the efficiency and performance of the overall portfolio.  The question is how an institution can best access its hedge fund exposure(s).  And, as is normally the case, there is no one-size-fits-all answer.   The most effective approach will depend on the size, structure, positioning and governance of each institution.  We will discuss the plusses and minuses of each approach.

In-house diversified trading.  Obviously, creating one’s own de facto hedge fund requires both significant scale and also a governance structure that can absorb and effectively control proprietary trading risks.  It also needs an environment where the levels of compensation can be sufficiently stratospheric to attract talent sufficient to justify not outsourcing to hedge fund managers.   This combination of factors is rare, but is used in many sovereign wealth funds, some insurance companies, banks, endowments and pension funds.  Interestingly, even with those entities, they normally use outside funds for specialty areas.

Direct investment into hedge funds.  Fifteen years ago, very few institutions invested in hedge funds and most of those did so through FoHFs.  At that time, there was far less information available on hedge funds – it was very much a cottage industry, with very few professionals with any real knowledge base.  There was an aura created by such early luminaries as George Soros, Julian Robertson and Paul Tudor Jones that both attracted investors and scared them away.  Investment approaches such as risk arbitrage, convertible arbitrage, distress and most derivative-related strategies were virtually unknown.  Over the past decade and a half, the growth in number of hedge funds, the total assets they control, together with the increased dissemination of information, growth of databases and press coverage has certainly popularized the area.  It has also, to some degree polarized it even further.  More information also means more misinformation and many potential investors have been scared away.  Nonetheless, there has been a dramatic growth both in overall understanding and demand.  As more and more Boards have been educated on the uses of hedge funds and they have engaged asset management professionals proficient in the area, they have actively engaged in hedge fund investing.  As they have gained experience, many, with sufficiently deep investment, operational and legal staffs, have decided the potential incremental protection of capital and shielding from headline risk, afforded by using an intermediary is insufficient to justify the extra layer of fees.

We believe there will always be a natural constituency that should and will invest directly.  As existing first-time hedge fund investors become more comfortable, many will migrate in this direction; ironically, however, we anticipate many who now invest directly are likely to experience one or more problematic situations that cause them to rethink their strategy and, perhaps return to using FoHFs.  For budgetary reasons, some organizations, as they restructure internal staffing might experience a need to outsource, even if the total cost is higher!

Use of a consultant to create hedge fund baskets.  A number of consulting firms have established a business of creating hedge fund portfolios on behalf of clients.  These range from specialist firms to some of the global full-service organizations.  The services they offer range from simply providing research and due diligence services to investors who wish to invest directly, but don’t have sufficient resources, to creating actual portfolios for their clients.  This is a potentially very valuable service and depends completely on the quality of the professionals they hire and the consistency they can provide.  A key issue is the level of responsibility the client can/desires to take for the end portfolio.  In many cases, the final decision of the composition of the baskets/portfolios lies with the client, not the consultant.  For many organizations this is desirable, as they prefer to take the active role in running their entire investment portfolio.  For others, this can create risks in the event of any erroneous decisions.

Use of a FoHF.  For most institutional investors, using a FoHF has and still is the first step into the world of hedge fund investing.  Although the general level of information flow, experience and sophistication has grown vis-à-vis hedge funds, the risk factors outlined above can be intimidating for a new entrant and, even with an experienced consultant advising, watching an intermediary deal with the issues remains a good initial approach.  The question is whether investors ‘evolve’ into other ways of accessing hedge funds.  The main reasons to use FoHFs are:

1. Good FoHFs have spent years building a strong team across all necessary areas and have already made a considerable number of mistakes, thereby hopefully helping their investors avoid making those mistakes.
2. For investors looking to deploy relatively small amounts, a FoHF still provides a good way of gaining diversification.
3. Because of their relationships, and in some cases, by working with smaller managers early on, FoHFs can often get more capacity with managers that are soft closed or approaching that level.  This remains the case for most investors, but larger institutions can certainly achieve the same results.
4. Because of a combination of the size of their aggregated investments and the length of their relationships, they can often negotiate better terms with managers.  When this relates to fees, it helps offset FoHF costs; with regard to liquidity and other technical terms, it is hard to directly measure the benefits.
5. It is easy to fire a FoHF.  In the event of bad performance or, even worse, a Madoff-type incident, the majority of the responsibility can be legitimately deflected.  In the ‘fishbowl’ environment in which most institutions now operate, the level of distraction caused by an erroneous investment, no matter how insignificant in relation to the overall portfolio, can be a massive distraction and can even have more serious consequences.
6.  In the event of another 1998 or 2008, when many hedge funds failed, gated, etc., the number of issues that need to be dealt with increase stratospherically.  Although there is a perception that direct investment into hedge funds provides more liquidity, this is often not the case.  The amount of time and effort it takes to work with hedge funds (on a friendly or more litigious basis) to retrieve assets, once they have become illiquid is enormous and winding down a portfolio can literally take years – something most institutions neither want nor, frankly are set up to do.
7. Although another ‘transparency filter’ is often cited as one of the strikes against FoHFs, many offer their investors access to the same materials they would get if they invested directly. Plus, because of their relationship with the managers and in-depth understanding of some of the specific subsectors, FoHFs can obtain and process additional information that actually can add to an investor’s understanding.
8. FoHFs are particularly useful for tracking down and evaluating lesser known hedge funds and for conducting ODD on those funds (small or otherwise) located in more unusual locations.  Except for the best-staffed institutions, this represents a practical problem.  To the extent more money flows into the hedge fund sector, much of it will flow into larger, better known managers, thereby most likely impeding their alpha generation; much of the interesting activity is likely to be with managers running more constrained levels of capital.

Offsetting these benefits are three concerns we hear voiced most frequently.

 

1. Cost.  This is by far the most serious concern.  Adding what historically have been significant fees on top of the high fees of the underlying hedge fund managers, means much of the alpha being generated does not reach the end investor.  Fee models have already started to change and we would anticipate there will continue to be more thoughtful fee structures going forward.  It is very important to note, however, the cost of running an institutional quality research, operational due diligence, portfolio management, operations and investor communications process is not inexpensive.  In order to maintain a diversified portfolio of 30 managers, a minimum staffing of two research analysts in research, one in ODD and two in operations/legal/compliance, etc. would be required. Top professionals on the research and portfolio management side can cost well into the six figures.  Travel and other expenses are also not insignificant. Naturally, to have a full-fledged research area, with full institutional capability requires far greater staffing.
2. Inefficacy.  Many FoHFs invested in Madoff and several of the other troubled funds of 2008.  As such, if these intermediaries can’t avoid the big problems, what is the need to engage them?  There is certainly merit to the concerns; however, as in any form of investing, there are few sure things.  We all operate in a world of probabilities and percentages.  The reason to use the best possible professionals to help make investment decisions is to increase the odds one will succeed.  By definition, one will not reach the desired outcome 100% of the time.  The key is to conduct the best possible due diligence upfront and choose the group(s) in which one has the most confidence – not necessarily the one that promises the most!
3. Distancing from information.  Many FoHFs do not provide full transparency. Even if an institution engages one that provides considerable information, there is a material difference between communicating directly and receiving information from a third party.  Regulators are certainly focusing on this issue.  In the end, however, so much depends on what information is sought and how it is absorbed.  The wrong person getting the right information is often worse than the right person receiving it through some filter.

Use a Hedge Fund Index.  In principal, this is a good idea.  However, there is a huge difference between theoretical indices and investible ones.  Given the capacity limitations, liquidity/rebalancing constraints, etc., investible indices are very constrained in which funds they can use.  As such, most such indices are little more than static FoHFs.

Hedge Fund Replicators.  The concept of looking historically at the principal drivers of return in various hedge fund styles, applying rigorous statistical analysis and disciplined trading is very appealing.  And when it works, it can be an efficient way of getting some differentiated types of exposure.  However, as in the debate between passive and active investing, the real question is whether there is value-added in finding off-the-run situations and in timing entry and exit points.  If one believes in the latter, going directly into hedge funds will be more appealing, even if the fees are higher. When a provider of replicators is willing, instead of selling replication to investors seeking hedge fund index exposure, to offer a true index while using its replicator to hedge itself, then we shall know replication has truly come of age!

Structured Notes.  These are merely wrappers that take the solutions outlined above and either add leverage, protection or merely regulatory/tax solutions.  They are neither inherently good nor bad – they simply add an additional frictional cost one needs to evaluate in making a decision.

ETFs  There are ETFs which will try to implement the long side of hedge fund-like strategies e.g. the current risk arbitrage universe or firms aggressively buying back shares.  The absence of an incentive fee gives these funds some performance cushion relative to the hedge funds with which they compete, their expenses may prove lower and their liquidity is certainly better. At the same time, they require the investor to actively manage their commitment to the sector, a function exercised by many underlying hedge fund managers,

and they run the risk of over-diversification. In addition, they are unlikely to exercise judgment in sizing individual positions based on the manager’s well-informed opinions.

CONCLUSION

It is a big world and there is no solution that will fit every investor all the time.  Hedge funds will be more or less popular at different times, as will consultants and FoHFs.  The key, as in all good decisions, is to carefully frame one’s goals and the risks associated and to choose the methodology that reaches those goals most effectively.

(This is a lightly edited version of a letter originally distributed in March 2011. Remarkably few of the facts or conclusions have changed since that time. Perhaps the biggest question mark surrounds commodities and their pricing.)

With the occasional fit and start and the occasional geographic exception, global equity markets continue to roar ahead. This seems to reflect a combination of strong short-term earnings and a true desire of investors to believe companies overall are well positioned to capitalize going forward. Does this reflect reality? Obviously, no one has a definitive answer, but it is hard to provide the world a clean financial bill of health. We have discussed many of the issues before, but it is probably worth stating a few unsolved problems around the world:

1. Very high levels of government debt and associated deficits in the U.S. and many European countries – without an apparent willpower to combat them in a meaningful way. This raises fears of rising interest rates, sovereign defaults and/or crowding out of private sector investment.
2. A financial system that is still dependent on artificially low interest rates to remain viable. Exposure to less than stellar credits puts many institutions at risk and it is very uncertain as to whether proposed regulatory reforms for banks, insurance companies and pension funds will improve the system or make it more tenuous.
3. Increasingly volatile and expensive commodities could certainly dampen growth, particularly in rapidly expanding, net commodity-importing economies such as China and India.
4. Wage pressures are increasing, not only in developing countries, but also potentially in the U.S. and other developed markets, as the concessions gained during the crisis are being fought by labor in the light of improved corporate profitability.
5. The deteriorating demographic profile of developed nations is not being accompanied by sufficiently aggressive policies of delayed retirement or healthcare cost confinement to obviate increasing government spending. This is likely to lead to higher overall levels of taxation and thereby lower disposable income.
6. A torrid advance in share prices among the most ‘vulnerable’ growth companies has the word ‘bubble’ being whispered; at the very least the risk/reward profile for investment in many companies has shifted materially for the worse.
7. The sprint for yield has turned a creditor recovery into a potential fixed income bubble.
8. Extraordinary changes in computer and communications technology perfect markets, improve communications and dramatically lower information costs. At the same time these are destroying long-standing franchises, can decimate profit margins of established intermediaries and completely up-end existing businesses based on information e.g. newspapers, telephone directories and broadcasting. The derisory valuations of many corporate icons associated with computer hardware stem from these apprehensions about the accelerated pace of competitive technologies.
9.  State direction and intervention in markets unprecedented since the Second World War, in which the boundary lines between private business activities and state policy can be difficult to discern, especially in energy and commodities.

It is remarkable that a mere three years after generalized problems in financial markets which gave rise to both widespread calls for root and branch reform of the financial system, and renewed criticism of financial markets per se, that these markets have recovered to the point where localized booms are common and risk tolerance has revived. Retreating from the brink and seeing a general corporate belt-tightening has created legitimate levels of optimism. Many portfolios have seen their equity component increase through appreciation, likewise higher risk parts of their fixed income allocations, yet the ‘beta’ focus remains surprisingly robust. Whereas the movement in the institutional world over the past decade has been towards carefully evaluating risk-adjusted returns, we perceive a notable shift towards simple returns. There seems to be a desire/need to fully cover the holes created during the crisis and a willingness to believe in the ability to shift allocation in time to avoid any severe market downturns. Obviously, some will be able to achieve this, but by definition the amount of ‘beta-alpha’ (the value added by anticipating market turns) is limited and in market downturns, most investors lose.

In an environment over the past year and a half, where correlations among securities and sectors has been particularly high (less so recently) and where volatility has also been high, the appeal of allocations to pure ‘beta-neutrality’ has waned, as a result of relatively less impressive returns. There has undoubtedly been interest in alternative ways of generating returns, but most of the underlying fundamentals have been based on being long the beta of specific sectors, rather than looking for differences between winners and losers in each of those sectors.

What is alpha, who wants it and why?

There has been an evolving interest over the past two decades in all forms of alternatives, initially by high net worth individuals and more recently by global institutions.  Not surprisingly, there has been an increasing amount of information available, of serious study and due diligence and of thinking about new ways to create and balance overall financial portfolios.  Although the general level of understanding has certainly increased, there remain significant lacunae and large areas of definitional inconsistency and confusion.  First, there is a general conflation of the terms ‘alternative investments,’ ‘absolute return’ and ‘alpha generators.’  This arises from the fact these are simply different from the traditional asset classes of bonds, stock and cash that have often represented the totality of a portfolio and still today generally represent the vast majority and have not, to date, enjoyed the same level of attention and study.

From our ongoing interaction with a broad range of investors, we perceive the rise in interest (since the turn of the millennium) in non-traditional investments to result largely from an understanding that increasing correlation among and within asset classes leads to higher systemic risk within portfolios.  Most institutions and many individuals, therefore, have sought higher levels of diversification.  The biggest problem, however, is that over the short-term, diversified strategies can appear correlated and correlated strategies can appear diversified.  By definition, alpha requires judgments that run contrary to the mainstream.  To the extent sentiment is unified (whether correct or not), the possibility for mean reversion decreases.  For most strategies, alpha manifests itself over a longer time period; as such, measurement criteria need to differ from those for traditional investments.  And, unfortunately, since ‘alternatives’ are not a true unified asset class, the metrics vary from strategy to strategy.

Real Estate.  Although both institutional and high net worth investors have had exposure to real estate for a long time, it is still often considered an alternative investment.  Given the general illiquidity of the area, it does not correlate directly with other asset classes, yet it is dependent on many of the same underlying fundamentals (e.g. a healthy economy, low interest rates, positive investor sentiment, etc.) and, therefore, has more underlying beta than often attributed to it.  Furthermore, from a portfolio tracking perspective, it also benefits from very infrequent marking to market which, by definition, leads to a lower level of correlation with more liquid strategies.

Thumbnail:      Underlying beta, less liquid, lower correlation.

Private Equity. The original concept behind leveraged buyouts was to acquire companies with steady cash flows, where leverage could easily be added and then rapidly paid down through the disposition of undervalued assets on the balance sheet.  As time has evolved, the area has largely become a combination of leverage, financial engineering and attempts at turnarounds.  Given the large exposure to the equity of private companies, the de facto beta is high, largely enhanced by the considerable leverage applied.  However, as the companies are most frequently private, marking to market is infrequent, resulting -as in real estate – in a lower ‘marked’ level of correlation than other more liquid strategies.  This does not signify value can’t be added from a return enhancement perspective, merely much less than commonly believed as a diversifier.

Thumbnail:      Leverage beta, alpha through financial engineering and corporate restructuring.

Venture Capital.  The ultimate beta plus alpha play.  As early-stage companies are not public, their marks are uncorrelated to their sectors or the market in aggregate.  Yet, most frequently their success is dependent on the same factors as their competitors in the public

markets.  From time to time there is a ‘breakout’ company that defies or redefines categorization, but this is not the majority of VC investments.

Thumbnail:      Illiquid beta, alpha through careful pre-selection of potentially differentiated sectors/companies.

Infrastructure. This, by definition, is a long-term play and often genuinely has lower correlation to equity markets.  However, the success of projects still often relates to levels of interest rates and the strength of the underlying economies in which they reside.  Furthermore, competition among strong, large competitors often limits the upside potential.  These investments are often much better diversifiers than return enhancers, but the liquidity/return tradeoff needs to be carefully evaluated as, in many cases, does the potential sovereign risk.

Thumbnail:      Alpha from differentiated cash flow streams dependent on significant illiquidity.

Hedge Funds are not a homogeneous category.  As such, in order to evaluate them properly, we have broken them down into some of their most frequently defined components.

Long/short equity:  Given the fact this area represents approximately 30% of hedge fund assets and 46% of actual hedge funds, it is by definition not a homogeneous sector.  Managers in this area can have widely disparate gross and net exposures, ranging from massively long to very short.  They can also be sector or geographic specialists or true generalists.  There is no single measurement characteristic.  This leads to a particularly high need to understand differences and set appropriate measurement criteria.  For example, which is a better track record, one with a ten-year 10% net return or one with a 15% net return?  Who knows?  The answer depends on the volatility associated with it.  If the 10% return came with  a volatility of 3% and the 15% with 50% volatility, an investor could have taken the first result, applied judicious leverage and come up with a better risk-adjusted return.  If the markets were up 12% a year and the 15% return was on average 150% net long, while the 10% was net neutral, an investor could have leveraged the index (without fees) for a portion of the investment and invested in the neutral fund for the rest to achieve a better risk-adjusted return.   The key in long/short equity analysis is to define a differentiated and sustainable research or trading edge – sufficient to justify the very high frictional costs (i.e. fees and expenses).  These are not easy to find over the long-term.  Over short periods it is less difficult to find outliers, particularly those dependent on beta.  However, those managers with skill and conviction are more likely to shine over longer time frames.  Furthermore, very few managers are able to generate sustainable out-performance through market timing, a.k.a. tactical allocation!

Thumbnail:      All over the map.  Distinct alpha generating possibilities, but often a significant amount of explicit or implicit beta.  Beware of paying alpha fees for beta.

–       Relative Value:   This primarily entails a largely quantitative search for and analysis of securities in the same or similar sectors, with the goal of going long those that are statistically undervalued and short those that are overvalued.  Depending on the closeness of the alignment, managers use varying degrees of leverage, sometimes exceeding 3 or more times!  Although these can demonstrate very attractive, steady returns and alpha, given their short-term neutrality, the tail risks, depending on the levels of leverage can be extremely high, particularly during periods of unexpected and/or extreme illiquidity.  Over the longer-run, this strategy often looks like selling naked options – a beautifully steady positive return stream followed by a significant loss, resulting in unattractive longer-term returns, particularly relative to the fees charged.

Thumbnail:          An alpha strategy that can suffer losses during periods of negative beta, when there is systemic illiquidity and leverage becomes dangerous.

–       Event:     Once again, this is a very broad-ranging strategy.  Originally dominated by risk-arbitrage, this has now broadened out to reflect a much more diversified range of corporate events and quasi-events.  It combines a fundamental analysis of companies that can hopefully be alpha-generating in and of itself and a probabilistic framework that assesses the upside and downside of specific events, allowing managers to take long and short positions, thereby limiting market exposure and creating alpha.  In actuality, practitioners vary from completely long to virtually market neutral.   The sector benefits from the level of corporate actions that stem from volatility, interest rates, high priced scrip (shares), etc.

Thumbnail:          Potentially highly alpha-generative, but often a high component of beta.  Often long fallow periods, requiring active rebalancing unless run as part of a more diversified multi-strategy fund.

–       Distress:  This entails the investment in the securities of companies going through periods of difficulty, either prior to, during or post the filing of bankruptcy proceedings.  It requires an ability to analyze the entire balance sheet of a company, understand the market environment for its sector, a full analysis of the legal ramifications of different actions (and the concomitant probabilistic outcome analysis), an understanding of the strengths – real and perceived – of holders of various classes of securities and a capital base that matches the duration of the securities in which the fund invests.  This is often largely a net-long strategy, but the beta will vary considerably depending on the class of security invested in.  Bank debt with short-term maturities can have virtually no beta, whereas junior subordinated debt in pre-petition companies can have betas of 2 or 3, as can post-bankruptcy equities.  Liquidity is often evanescent and patience is required.  It is also a highly cyclical field – opportunities exist most when default rates are higher and debt is hard/expensive to issue.  There can be very long periods when the returns to this area can be dull and disappointing, and losses can be very high in the event of a large shift from optimism to pessimism.

Thumbnail:    Often strong alpha potential, although a distinct beta component.  Need a willingness to accept illiquidity.  Often high differentiation among market participants.

 

–       Global Macro:  By definition a very broad category, almost un-definable and frequently unpredictable.  A manager can be diversified or focused, levered or unlevered, directional or not (either way); the general unifying definition is more top-down than bottom-up.  This is the ultimate game of combining conviction with timing.  Most fail; those who succeed can do so in a spectacular way.  This is generally used as a diversifying strategy, which it often is.  Unfortunately, the downfall of many macro traders is being down as much or more as beta managers during market meltdowns or periods of illiquidity that they didn’t anticipate.

Thumbnail:          A potential diversifier with strong alpha, but not necessarily a hedging strategy.  Can have enormous beta at times, but not predictable. Enormous long-term differentiation among participants.

–       Short-term Trading:       This can be both purely statistical, purely qualitative or a combination of both.  A true believer in efficient markets would dismiss the alpha generating capability of this area.  However, markets often don’t adjust as quickly as they theoretically should and there are practitioners who can profit from this.  The returns are often very uncorrelated and the area has had a more constrained downside than the other strategies outlined here.  The upside, however, is also constrained and any analysis needs to carefully factor in the high frictional costs required to generate often modest absolute long-term returns.

Thumbnail:          Potentially alpha generative, with limited downside, but with relatively constrained absolute returns relative to fees and expenses.

–       MBS:      Historically a very large area of issuance, much more reduced since the sub-prime debacle.  The securities are in and of themselves highly complicated and the strategies of trading around them equally so.  The pure relative value plays, included in the category above as well, have often generated steady returns for a period but have then been subject to severe damage in many periods of illiquidity or unexpected shifts in the shape of the Treasury curve.  We don’t anticipate this to change.  For more tactical investors, because of the complexity and mistrust, there can be periods of interesting risk-adjusted opportunities.  Not an area for those not willing to drill down deeply and fully understand the risks.

Thumbnail:          Very uncorrelated, with distinct alpha generating potential, but a high level of complexity and many other forms of risk.

–       CTAs:      The trading of hard and soft commodities and financial instruments can provide highly differentiated returns.  Depending on the leverage and directionality, the risks can be extremely high.   Often viewed as a good hedge for the rest of the portfolio, this can be true.  However, as most CTAs depend on trend following, a rapid shift in a trend, contemporaneously with a shift in the markets can result in CTAs being down as much or more as their supposedly more directional counterparts.

Thumbnail:          Potentially a diversifier and alpha generator.  Uncertain levels of beta.  Risks depending on leverage and ability to shift out of trends at the right time.

What are investors looking for?

Returns!  Obviously, investors are always looking for returns. Their equity and fixed income allocations are what they are.  They have portfolio guidelines they need to meet and allocate accordingly.  These are mainly beta-driven, with a desire in many cases for alpha around the margin.  Although the events of 2008 and their impact on alternatives put most strategies and managers in the penalty box, the concern about the bounce-back, over-valuation, risk of rising interest rates has brought many PMs back to considering various options within alternatives.  However, experiences of the past have an impact on current investment patterns.  In some instances this is very productive – i.e. taking more time to understand an underlying strategy, questioning process, structure, fees, governance, etc.  In others, it surfaces contradictions – i.e. as a result of bad experiences with redemptions, seeking greater liquidity in strategies that can’t fundamentally support it.  Ironically, it has also shortened the measurement time–frame for many managers.  Strategies that previously were measured on a rolling three-year basis are perhaps now measured on a rolling one-year basis.  This sets an expectation of behavior pattern for managers and allocators – you will be measured in a certain way, therefore it behooves you to try to maximize returns over that time period (with the unstated and perhaps unintended ellipsis of “whether or not that fits your strategy and/or style”).  There is a huge current premium on ‘beta alpha,’ the ability to time allocations in and out of strategies.  In the old days that was called market timing – tried by many, successfully implemented by few.  The same is true today.  Looking back three years from now there will be a group of winners and a much larger group of losers.

Speaking two years on, my guess of a three-year time window has understated the willingness of governments to maintain an easy money posture. My conclusion is no different, merely pushed out by some period.