Commentary on Political Economy

Wednesday 30 June 2021


US and Japan conduct war games amid rising China-Taiwan tensions

Secret table-top planning and joint exercises in South China Sea continue as concerns grow over Beijing stance

The US and Japan have become alarmed as China has flown more fighter jets and bombers into Taiwan’s air defence identification zone © Taiwan Ministry of Defense/AP

The US and Japan have been conducting war games and joint military exercises in the event of a conflict with China over Taiwan, amid escalating concerns over the Chinese military’s assertive activity.

US and Japanese military officials began serious planning for a possible conflict in the final year of the Trump administration, according to six people who requested anonymity. The activity includes top-secret tabletop war games and joint exercises in the South China and East China seas.

Shinzo Abe, then Japanese prime minister, in 2019 decided to significantly expand military planning because of the Chinese threat to Taiwan and the Senkaku Islands in the East China Sea. This work has continued under the administrations of Joe Biden and Japanese prime minister Yoshihide Suga, according to three of the people with knowledge of the matter.

The US and Japan have become alarmed as China has flown more fighter jets and bombers into Taiwan’s air defence identification zone, including a record 28 fighters on June 15. The Chinese navy, air force and coast guard have also become increasingly active around the Senkaku, which are administered by Japan but claimed by China and Taiwan. 

China insists that it wants to unify Taiwan with the mainland. While it says it wants peaceful unification, it has not ruled out the use of force to seize control of Taiwan.

“In many ways, the People’s Liberation Army drove the US and Japan together and toward new thinking on Taiwan,” said Randy Schriver, who served as the top Pentagon official for Asia until the end of 2019. “Assertiveness around the Senkaku and Taiwan at the same time drives home the issue of proximity.”

The US has long wanted Japan, a mutual defence treaty ally, to conduct more joint military planning, but Japan was constrained by its postwar pacifist constitution. That obstacle was eased, but not eliminated, when the Abe government in 2015 reinterpreted the constitution to allow Japan to defend allies that came under attack.

As the two allies started to bolster their joint planning, Japan asked the US to share its Taiwan war plan, but the Pentagon demurred because it wanted to focus on boosting planning between the two countries in phases. One former US official said the eventual goal was for the two allies to create an integrated war plan for Taiwan.

Two of the six people said the US military and Japanese self-defence forces had conducted joint exercises in the South China Sea that had been couched as disaster relief training. They have also held more military exercises around the Senkaku, which also helps prepare for any conflict with China over Taiwan, which is just 350km west of the islands.

“Some of the activities we’re training on are highly fungible,” said Schriver, adding that exercises such as an amphibious landing in a “disaster relief scenario” would be “directly applicable” to any conflict around the Senkaku or the Taiwan Strait.

Mark Montgomery, a retired admiral who commanded the USS George Washington aircraft carrier strike group and was director of operations at Indo-Pacific command between 2014 and 2017, said the Pentagon needed a “comprehensive understanding” of the support Japan could provide in the case of a conflict.

Senkaku Islands
Tension has risen over the Senkaku Islands, which are administered by Japan but claimed by China and Taiwan © Kyodo via Reuters

“As a crisis grows and Japan is potentially drawn in as a participant, the US will need to understand how Japan could support or enable US operations,” he added. 

US and Japanese diplomats are examining the legal issues related to any joint military action, including access to bases and the kind of logistical support Japan could provide US forces engaged in a conflict with China.

In the event of a war over Taiwan, the US would rely on air bases in Japan. But that raises the odds that Tokyo would be dragged into the conflict, particularly if China tried to destroy the bases in an effort to hobble the US.

One official said the US and Japan needed to urgently create a trilateral sharing mechanism with Taiwan for information about Chinese naval and air force movements, especially around the Miyako Strait to the east of Taiwan which is covered by Japanese sensors from the north-east and Taiwanese sensors from the south-west.

“Some of that kind of data is shared between Taiwan and the US, and between Japan and the US. But we have no direct sharing trilaterally,” the official said. “You cannot start setting that up in the middle of a contingency. You have to do it now.”

Another official said the three nations had taken a small but important step in 2017 by agreeing to share military aircraft codes to help identify friendly aircraft. 

Taiwanese officials and US and Japanese sources said co-operation had since risen significantly, driven by the growing awareness in Japan about the importance of Taiwan — which is 110km from Yonaguni, the westernmost island in the Japanese archipelago — for its own security.

“The Japanese government has increasingly recognised, and even acknowledges publicly, that the defence of Taiwan equates to the defence of Japan,” said Heino Klinck, a former top Pentagon official who oversaw military relations with Japan and Taiwan from late 2019 until the end of the Trump administration.

The Japanese defence ministry said Tokyo and Washington continued to update their joint planning following the 2015 revision of guidelines that underpin the military alliance, but declined to provide any detail. The Pentagon did not comment.

Follow Demetri Sevastopulo and Kathrin Hille on Twitter

Additional reporting by Robin Harding in Tokyo

Tuesday 29 June 2021

Rising China bond yields prompt fears over coming surge in defaults
Investors in $17tn credit market ditch debt issued by groups in financially weaker provinces 

 High-rises stand partially empty in Tianjin, China. The region is one of several being closely watched by investors as fears over defaults rise 

Rising investor concerns over shaky finances in China’s most economically fragile provinces have prompted a sell-off in state-run groups’ bonds, as analysts warn of a surge in defaults in the country’s $17tn credit market. The median yield on bonds issued by state-owned enterprises in six large provinces and municipalities that suffer from weak finances jumped to more than 5 per cent in the second quarter, up from less than 3.5 per cent a year ago. That contrasts with a nationwide trend in which most SOE bond yields have crept lower over the past six months. Yields rise as bond prices fall. The financial stresses underscore how Covid-19 and China’s subsequent economic recovery have deepened the divide between the country’s more dynamic regional economies and its less-developed ones. They also come as global investors increasingly scrutinise China’s bond market, where confidence has been rattled by a series of state-linked defaults. The six regions being closely watched by investors — Hebei, Henan, Liaoning, Shanxi, Tianjin and Yunnan — have so far been able to avoid mass defaults as provincial authorities have stepped in to prevent a handful of missed payments cascading into a more serious wave. Across China, S&P calculates that Rmb4.2tn ($650bn) of bonds are due this year as well as Rmb1tn in put options that give bondholders the right to early repayment. While “only three” SOEs in these regions defaulted in March and April, such “muted” defaults may be “temporary”, wrote analysts at Fitch Ratings in a note. “The secondary market pricing has already factored in, to some extent, those rising default risks in those weaker regions,” said Shuncheng Zhang, a Fitch analyst in Shanghai. “Some regions — like Yunnan and Tianjin — they have seen a pretty notable surge in the secondary market yields.” The fears over rising defaults also come as investors increasingly question Chinese authorities’ appetite for bailing out troubled SOEs. The pandemic has stretched the finances of some regional governments, analysts at S&P Ratings said, leaving fewer funds available for rescuing state-run companies. “SOE support is more selective, and tolerance for defaults is rising,” the S&P analysts said. “This means an increased willingness to allow unprofitable SOEs to go bankrupt.” Fitch analyst Jenny Huang said Beijing has been “very clear” about its intention to challenge long-held assumptions by state-linked borrowers and their investors that the government will step in to support them if they hit trouble. Liu He, China’s vice-premier and Xi Jinping’s economic tsar, has led a campaign in which regulators have intensified scrutiny of the country’s corporate debt market and tightened lending to debt-laden SOEs. Beijing has attempted to “test the water” with defaults among SOEs and investors are closely watching how a similar approach might be expanded to institutions like cash-strapped investment groups that are linked to local governments, Huang added. Recommended The Big Read The Communist party at 100: is Xi Jinping’s China on the right track? Analysts said that while there have been fewer Chinese corporate defaults this year, the scale of missed payments has grown. In the first six months of 2021, 11 issuers with Rmb95bn of bonds defaulted, compared with 17 issuers and Rmb92bn in the first half of 2020, S&P said. Each defaulter this year had on average three times the value of bonds outstanding compared with in 2017, and nine-times that of 2015. S&P analysts said that “defaults are increasingly higher-profile, with bigger impact on markets and investors”.


Monetary policy is not the solution to inequality

But the necessary structural reforms will be harder than many economists imagine

James Ferguson illustration of Martin Wolf column ‘Monetary policy is not the solution to inequality’
© James Ferguson

Should central banks do something about inequality and, if so, what? This has become a hot topic, which has persuaded the Bank for International Settlements to focus on it in its latest annual report. Its conclusions are what one would expect: monetary policy is neither the main cause of inequality nor a cure for it. Broadly speaking, this is correct. But in a world in which central bankers have become such aggressive actors, it may not be enough.

A striking fact noted by the BIS is that since what it calls the “Great Financial Crisis”, the proportion of speeches by central bankers mentioning inequality has soared. This partly reflects rising political concern about inequality. But it also reflects a specific critique. This is, in the report’s words, that “central banks have deployed policies featuring exceptionally low interest rates and extensive use of balance sheets to support economic activity and lower unemployment. Such measures have fuelled concerns that central banks’ actions, by boosting asset prices, have benefited mostly the rich”. That critique is popular among conservatives who detest activist central banks. (See charts.)

Yet there is also an opposite critique from people who upbraid central banks for not being activist enough. People in this camp argue that the failure has been to be too passive, letting inflation remain too low and labour markets stay too weak. At present, central banks, even the European Central Bank, are far closer to this position than to the more conservative one. Central banks, one might assert, have become more than a little “woke”.

Column chart of Central bankers' speeches: per cent mentioning 'inequality' or 'distributional impact/consequences' showing Central bankers become increasingly 'woke' on inequality

This is an important debate, bearing on the legitimacy and consequences of what central banks are doing, especially in this era of crises. The view of the BIS itself is threefold. First, the rise in inequality since 1980 is “largely due to structural factors, well outside the reach of monetary policy, and is best addressed by fiscal and structural policies”. Second, by fulfilling their monetary mandates, central banks can reduce the impact of shorter-term shocks to economic welfare caused by inflation, financial crises and, no doubt, real shocks (such as pandemics). Finally, central banks can also do something about inequality with good prudential regulation, promoting financial development and inclusion and ensuring safe and effective payments.

Line chart of Stock and equity prices, average* of US, Japan, Germany, France & UK (Q1 2007 = 100) showing Asset prices have risen strongly since the global financial crisis

All this is sensible, so far as it goes. It is clear, for example, that falling real interest rates and easy monetary policies have tended to raise asset prices, to the benefit of the wealthiest. But, interestingly, the measured impact on wealth inequality has not been as dramatic as one might have expected. More important, it would have made no sense to adopt a deliberately more restrictive monetary policy solely in order to lower asset prices. This would have reduced activity and raised unemployment. That is the worst thing that could happen to people who are dependent on their wages for their livelihoods. Meanwhile, how would the majority of people, who own almost no assets, be better off because billionaires were a bit poorer? It would be mad for central banks to cause slumps in order to lower asset prices.

Line chart of Wealth inequality (% share held by top 10 per cent and 1 per cent of population) showing The limited evidence does not suggest soaring wealth inequality

A more relevant concern is raised by the dominant contemporary demand to “run the economy hot”. That raises two real (and possibly related) dangers: inflation and financial instability.

On the former, proponents of this approach argue that one cannot know where the risk of significant inflation lies without pushing the economy not just to, but beyond, the limit. But that could also prove costly if, as some fear, inflation soars and that overshoot proves very expensive to reverse.

Line chart of US employment by income level, % change since Jan 2020 showing The crisis hit poor workers far harder than rich ones

On the latter, it is hoped that sophisticated regulation will contain financial instability, even in the easiest imaginable monetary environment. That could be true, under ideal regulation. But regulation is never ideal. Moreover, it is already easy to identify vulnerabilities, notably in the non-bank financial sector. There is simply so much debt. That may be fine if interest rates stay low. But will they? Focusing on outcomes, not forecasts, makes this less likely.

Where the BIS is clearly correct is that fiscal and structural policies are the main way to address inequality. Indeed, some high-income countries are quite effective in using the former in this way. The big contrast between the US and other high-income countries in income inequality, for example, is in the relative absence of redistribution in the former. In some big emerging economies, there is little redistribution, especially in supposedly socialist China.

Dot plot comparing gini index for advanced and emerging economies

Structural policy is a still more complex issue. Too often, this is just a synonym for market liberalisation. But financial liberalisation has surely increased inequality and financial instability. So, good structural reform would almost certainly seek to constrain finance. Similarly, in labour markets with significant monopsonies, labour market deregulation might well be bad for employment and inequality. Moreover, rising inequality is almost certainly a factor in creating the structurally weak demand that explains the declining real interest rates and soaring indebtedness characteristic of our era of “secular stagnation”. For all these reasons, the structural reforms we should be thinking about are more difficult than conventional wisdom imagines.

The BIS is right that monetary policy cannot solve inequality. It can only aim at broad macroeconomic stability. Even that is hard to achieve, given our chronic reliance on expansionary monetary policy. In this context, financial excess is sure to re-emerge, making regulation an unending game of “whack a mole”. The BIS is correct to call for radical structural reforms. But they have to be the right kind of structural reforms.