Winning Without War

“War is an ugly thing, but not the ugliest of things. The decayed and degraded state of moral and patriotic feeling which thinks nothing is worth a war, is worse.” – John Stuart Mill, before the battles of Somme and Verdun during the First World War

India has a geopolitical problem with Pakistan and with China also an economic one. The fact these two also happen to be its two largest neighbours also means that they will possibly never go away, it needs better management.

Ancient Greek philosophy believed conflict is omnipresent and in that environment, being prepared is the only deterrence. Neither empathy, understanding or good intentions can resolve the issue. We saw this in operation during the recent Doklam crises as China undertook an operation to change the status on the ground Indian forces with better force posture locally and political support ensured that the status quo was maintained. In Schelling's 1966 work on deterrence, it argued the concept that military strategy can no longer be defined as the science of military victory. Further, that military strategy was now equally, if not more, the art of coercion, of intimidation and deterrence. But to be coercive or deter another state, violence must be anticipated and avoidable by accommodation. So simply put, deterrence is not only defined by capacity but also by the desire and ability to use it. Capacity in today’s day and age is complex (Complex because a single missile fired means coordination between local intelligence, satellite based locations, missile launch command, missile tracking systems, damage assessment) and expensive (just to pick up some hardware – B-2 bomber over $1bn, Abrams tank over $4m, 1 GPS guided artillery shell ~$150,000 or assault rifles over $1,000). India has shown limited ability to inflict damage (except the 2016 cross border raid into Pakistan) despite grave provocations be it Mumbai attacks of 2008 or continued Chinese incursions. Deterrence has limited meaning when one state shows no desire or ability to exercise its might whereas another state can continue to call it unauthorised and uncontrolled action by non-state players.    

A continued economic well-being is important to capacity building in the society. One can see the detrimental effects of a stagnant economy in Europe – how state structures are collapsing as pressure from unemployment is dissipating and changing the political landscape. The massive stimulus program the Chinese adopted in 2008 was in response to this potential social pressure where exports fell 25% (or 8% of GDP) and 25m migrant workers returned home. As India pushes to formalize its economy through GST and demonetization, taking measures to reduce the subsidy burden like free pricing of fuel, or pushing financial assets as against physical assets, the savings capacity of the country and, therefore, our local investment capacity should improve significantly. Higher investment during the 2004-2008 period is what created the conditions for high economic growth. But in a world of Chinese over-investment as I have pointed in my earlier articles, this investment can only be achieved by erecting trade barriers or non-trade ones in areas of national importance like pharma, semi-conductor, electronics or government giving additional incentives. While China will face the detrimental effects debt and of precipitous decline in working age population (and is therefore investing heavily in robotics and AI), India can have a social disaster if it does not provide jobs for its expanding work force.

China’s best partners in Asia are Pakistan and on a good day North Korea. India needs to exercise its national might on the geographic advantage that it enjoys. It sits between the Middle East and the Far East astride the Indian Ocean, practically allowing it dominion on all that transits in between allowing it to exercise influence Africa to Indonesia. It is protected by the Himalayas in the north and the dense forests in the east, which is why China and India never before have fought wars. Only now technology allows each other to inflict damage but creating logistical lines through the Himalayas or via the Indo-Pacific is still a herculean task. Using the Andaman Island chain, India can very effectively bottle up Chinese navy or trade. The only territory that has ever threatened India has been territory via Pakistan. This is the only practical and sustained power projection into India and outside by India. And, this is where China wishes to build the China Pakistan Economic Corridor allowing greater capability on India’s western borders. India needs to shed its reluctance and mindset where alliances meant giving up sovereignty and build firmer alliance structures as PM Abe has suggested with US, Japan and Australia. This alliance structure will not only allow it to improve its defence capability through technology sharing and training but also build specific mutual defence arrangements which could range from simple arms assistance at times of conflict to NATO like joint defence pacts.  

The final and most important aspect in this is strategic patience. 

• Pakistan has sought project itself as pivot to this part of the world to the best benefactor it can find in town since it came into existence. While it did this in a continuous effort to allow it parity with India, both its economic as well as social stability now lies threatened. It’s credit rating is the same as Rwanda or Jamaica, with debt over $82bn, reserves less than $20bn and a rising current account deficit (exceeding $3.5bn in the previous quarter). The decline in oil prices have reduced the inflow of aid and remittance from the Middle East, further impacting economic stability. There is the largest concentration of terrorist group that any country has with rising ethnic divide between Punjabis and other constituents like Balochs or Sindhis. In addition, the CPEC corridor with its market rate loans will exacerbate the current account deficit. China also tends to bring its own people for the construction activities and managing the plants allowing for limited local capacity building. Further, if there is a bias in internal distribution of projects it will also cause further dissension. China believes that it can control the outcomes in a politically disturbed country while allowing it to stabilise Xinjiang and helping it work around the Malacca dilemma. Pakistan believes that it will bring it greater control over Baluchistan and allow it to use China more effectively to balance against growing Indian capability. 
• While Pakistan faces a political and economic crisis, China believes it can defy the laws of economic gravity. China’s Tier 1 housing costs are between 50-100 times household income with the likelihood China residential property value may have already surpassed value of the entire world. The stimulus economy it’s created has pushed debt in China to 330% of GDP which has resulted in interest expense being more that incremental nominal GDP since 2011!! At current pace China household debt which is about 60% of GDP in June 2017 is expected at current pace to be 90% of GDP – same as US pre-crises debt levels. In 2014, China forex reserves was 20% of money supply and 55% of household savings. Both these numbers have dropped now to 10% and 30% respectively, which heighten the risk of any panic by households. With continued forex outflow through the trade channel despite the severe restrictions on capital outflows, any issue in this can only be stemmed with a politically problematic devaluation. Recently, Governor Zhou of the China central bank outlined the rising financing risk in the system (https://www.bloomberg.com/news/articles/2017-11-04/china-s-zhou-warns-on-mounting-financial-risk-in-rare-commentary). As China puts capital restrictions so will it restrain FDI which despite be a small proportion of total capex in China (~2.5%) is important given its impact. For example, Enright, Scott & Associates estimates that the impact of US firm Procter & Gamble alone – with its supply chain and distribution channels – was more than US$11 billion on China’s GDP and 600,000 on the nation’s employment in 2014. Why should someone bring in money if they cannot withdraw? The One Belt One Road construct which will mean spending of US$1trillion in countries with low credit rating and still lower abilities to absorb such investments given the high levels of corruption and low human capital base, unlike the Marshal plan post WWII which was in countries with deep human capital and long history or rule of law. Further, it is not that the Chinese are looking to open opening up their markets for cheaper imports to allow these countries to expand their productive capacity. It is unlikely that OBOR will succeed. The Chinese, I am sure, understand their economic predicament of excess debt and bad demographics and they are dealing it in exactly the opposite way the Soviet Union under Gorbachev dealt with it, consolidating control under Xi than loosening as in the case of Perestroika.

It is in India’s interest to keep building internal capacity and global partnerships, and allow the forces to nature to do their work. Chinese economic slow-down/recession will stall military expansion and consequently change behaviour of not only its own but also Pakistan’s which will see the retreat of its 3^rd benefactor after US and Saudi Arabia.

In summary, Deterrence, Economic Growth, Partnership and Patience are the four pillars on which India needs to build the next 5-7 years of its global and regional politics. And, when it gets the opportunity change the ground status in its favour be it in Tibet or in Pakistan or its immediate neighbourhood. Clausewitz, On War, “We can also undertake a limited defensive war, of which there are two distinct kinds.  In the first, we aim to keep our territory inviolate and hold it as long as possible, hoping time will change the external situation and relieve the pressure against us.  In the second, we adopt the defensive to help create the conditions for a counteroffensive and the pursuit of a positive aim.”

"If you love me as you say you do,' she whispered, 'make it so that I am at peace.” ― Leo Tolstoy, Anna Karenina

Two Potential Changes, Changes the Entire Paradigm of Asian Security

With North Korea going nuclear, the impact on the security paradigm in North Asia is immense. The North Koreans see the nuclear weapon as a way of regime security and they are correct, until they use them when the response will be disproportionate. This is more so since Gaddafi government in Libya gave up their WMD program only to have Washington turn on them.

The Chinese are extremely afraid of two possibilities, one the collapse of the regime sending large number of refugees across the border and destabilising their North-East area and second a merged Korea supported by United States at their border. The South Koreans do not want a war given the proximity of Seoul to the North Korean border and its artillery, notwithstanding nuclear weapons. The Japanese are more ambivalent of the situation given the distance and whether North Koreans would like to draw in practically all sides to war. The US is the only player really capable of action against the North Koreans and it is they who have to decide whether they could like to back down and use containment and deterrence or make war now. A quick look at the table below highlights the defence disparities.

US$ bn	1995-1999	2000-2004	2005-2009	2010-2014	2015	2016	Cumulative >1995
Japan	41	42	41	41	41	42	904
China	31	59	106	171	214	226	2,274
India	22	29	39	49	51	56	805
Russia	19	25	38	53	66	70	811
US	410	484	658	695	596	606	12,442

Source: SIPRI, Defence Expenditure in Constant US$ 2015. Note: All 5-year periods are simple-averages.

Military systems are acquired over decades and it is not as much near-term but the long-range spending that matters. And, above does not capture the spends of the 5 decades before that on building up various bases and infrastructure. Training and perfecting the procedures itself takes time. And, US is practically the only country in permanent state of war. I am not looking to pass a moral judgment but real-life situations on daily basis help perfecting not only the machines, communications and bombs but also training of soldiers. Like Thucydides said in his epic about the Greek world where the city state of Athens was the maritime super power, “In other ways, too, the Athenians were no longer as popular as they used to be: they bore more than their share of actual fighting, but this made it all easier for them to force back into alliance any state that wanted to leave it.”  

The Chinese have been bartering their leverage with North Koreans for decades for better trade deals with the US. This is exactly how they played it in the first meeting between Trump and Xi only hoping things would not get as far as they have now. But China does not want to exact the ultimate price of stopping all fuel and critical supplies for the fear of North Korea turning on them as well or causing a regime collapse. Only reason they probably voted for UN sanctions was for the fear of trade sanctions. They may be willing to go further for American concessions on Taiwan. But that would be complete foolhardiness on the part of the US.

The real joker in the pack would be if America were to signal a willingness for Japan and/or South Korea to go nuclear in response to North Korean provocations. This would force China, North Korea and Russia to re-configure their security plans dramatically. Japan surely has the technologically capability of going nuclear given its sophisticated industrial base and given the Chinese threat it is only a matter of time where the Japanese may not feel fully comfortable with the American security umbrella and American’s may be more comfortable with a shared security burden, a direction in which Japan has been moving. The only big psychological barrier is the history of Japan in World War II.

It is not that the Chinese are not aware of the possibility, it is just not in the realm of reality yet.

The second is the state that builds an alliance with Iran has the opportunity of creating a new security paradigm in the Middle East. That the Saudis and the Iranians are fighting in every nook and corner in the Middle-East is well known – Yemen, Iraq, Syria, Bahrain or Qatar. But Iran is the more benign, powerful and stable of the two. I had written about this in greater depth in April 2015 (http://poleconomyindia.blogspot.in/2015/04/re-engaging-ancient-empire.html).

If the US were to turn around at some point and embrace the Iranians, it would create a frightening possibility for Saudi Arabia, Pakistan and Turkey. These countries have enjoyed significant patronage from the Americans. This has the possibility of stabilizing Afghanistan given the large land border from Iran to offer a counter to Taliban / other networks and possibilities of achieving a solution in Syria. If the Chinese, were to achieve this possibility despite American sanctions, it would open the internal route to Iranian oil via Turkmenistan and Pakistan stabilising the Uighur region. It would also open tremendous possibilities within the Central Asian countries given the influence the two countries would wield and would provide China an ability to emerge as a player in the Middle East. Although, given the alignment with Pakistan is a concern for the Iranians. For the Indians, Iran offers the only opportunity of opening up trade and access routes to Central Asia and to establish a permanent land route to Afghanistan and Pakistan’s restive province of Baluchistan. Both these are impossible without Iran.  

History moves in cycles. Countries interests dictate their moves. These changes will occur, only question is time and the manner. 

When Economics Plays Politics

Japan then South-East Asia and now China (and Germans before), the story remains broadly the same ensure political control over national savings, invest in creating factory and infrastructure capacity far in excess of domestic markets needs and export to the European and especially the US markets. Corollary to this, use the net exports to build large enough dollar currency reserves to hold down the local currency. This story as we can see has played out multiple times before. But this time it’s different, in four critical ways:

• GDP growth is productivity growth and population growth. Both these have slowed down or reversed in the developed markets. Consequently, the ability to consume has only been enhanced in recent times by a reduction of savings (or expansion in indebtedness) in US and Europe rather than an expansion of incomes as before;
• The scale of investment relative to the world that the Chinese are doing is unprecedented. For a country whose consumption is only about US$4 trillion or about 10% of global consumption, it is annually investing closer to US$5 trillion which is roughly equal to 25% of the global investment. Japan at its peak in the late 1990s was investing just about a third of its GDP, the Chinese are investing almost half. With more sophisticated supply chains built now this results in imposing a prohibitive cost to investments anywhere on the globe;
• Robotics, automation and artificial intelligence are making humans more and more redundant. This is rendering humans less relevant in planning production locations. That Foxconn plans to put a plant in Wisconsin (US) for Apple products is made possible by this factor as much as other issues;
• Lastly, the global financial crises of 2008 which in many ways was a manifestation of the first point led the central banks to adopt policies which made the returns of middle class savings and pensions returns practically zero, while the asset inflation that ensued have made the wealth distribution even more unequal.

Source: CBO, US

The global liberal order which was very much an American creation post WW II was shaped but a large middle class allowing American borders to be politically open to trade and finance. This, however, is under pressure. In Capital in the Twenty-First Century, French economist Thomas Piketty argues that "extremely high levels" of wealth inequality are "incompatible with the meritocratic values and principles of social justice fundamental to modern democratic societies" and that "the risk of a drift towards oligarchy is real and gives little reason for optimism about where the United States is headed."

The election of Donald Trump and the campaign of Bernie Sanders was an indicator of manifestation of the anger of American public on the economic insecurity that has built up over the last two decades. The revocation of TPP, the talk of unwinding NAFTA and more recently steel sanctions are pointers to a 180-foreign policy change to country which has been more intent in securing foreign markets and offering its own. In November 2016 article I had written, “The US single-handedly consumes as much as the next 5 countries of the globe and 26% of total global consumption or 5% of the globe’s population consumes >25% of global production. It has added in the last 8 years 3x debt for every dollar added to GDP. I had discussed this in an article in December last year in greater detail (http://poleconomyindia.blogspot.in/2015/12/imbalance.html). Which means the US economy provides jobs across the world to support its consumption while middle America production belt suffers.”  

The US public focussed on domestic issues is changing the political discourse in Washington. It’s interest in global affairs is diminishing, also tired from Afghan and Iraq adventures, – be it Afghanistan or Middle East except maybe North Korea as it threatens to nuke the US mainland – and this is creating fear across states as the established security order suffers. While the Europeans seem to show no stomach for a fight, the Baltic and Eastern European states are frightened by Russian moves to resurrect their buffer zone, Japan is changing course to react to greater Chinese power and less trust on American security guarantees as is India and South-East Asia and Middle East is a free for all.

To add on top, it’s not that the American economy at a macro level doing well:

• Real GDP growth has been 1.97% and 0.83% over last 3 and 5 years respectively;
• Federal Government debt is 106% or 2x more than 2000 and expected to be 130% in 10 years;
• At $8.6trillion corporate debt is 30% higher than September 2008;
• Productivity continues to fall and is approaching zero;
• Fed balance sheet is 6x larger than pre-crises level and it wants to start trimming it 9 years into the current cycle (one of the longest is US economic history);
• The S&P 500 Cyclically Adjusted PE is only been greater once in 1990s and is almost same levels preceding Great Depression and when higher than 1920s when adjusted for economic growth trends;
• Total domestic corporate profits have grown at annualized .097% in last 5 years and over the last 10 years S&P 500 corporations have returned more money than they have earned;
• The list goes on…

(Source: Michael Lebowitz)

The political and the geopolitical problem will only get worse if the economy turns over…and, of course, economics plays politics all the time but then there are those times when it really matters.  

Likely Age of Technology Leap

The global geopolitical fracture is also likely to lead to higher defence expenditure. This also is likely to herald, if past is anything to go by, a period of great technological change. How it affects political power (like in the case of nuclear bombs) or changes in economic course. Many significant pieces of tech we use today came out of military technology – the micro-processor first invented to guide inter-continental ballistic missile or GPS to help military find location or internet developed as a fail-safe communication protocol in case of nuclear war. Or sample this a list drawn by the French Military in 1993 to classify technologies they were working on:

• totally military technologies, lack of duality (nuclear technologies, electronic warfare, stealth furtivité, etc.);
• technologies moderately dual (missile propellants, lasers, etc.);
• technologies partially dual (optics and optronics, electromagnetic, acoustics, etc.);
• technologies largely dual (aircraft engines, super-computers, etc.);
• technologies totally dual (Computing tools for complex systems integration, Modelling and simulation for complex systems integration, Artificial intelligence and neural networks, Industrial systems of production (including robotics), Materials treatment and shaping, Ergonomic and neuroscience)

These classifications will however change with time as they did with cellular telephony. But the government’s ability to spend and acquire resources on futuristic technologies for battle-field superiority is far deeper than any private body.

For example, Defence Advanced Research Projects Agency (DARPA) is spending on developing solar powered stratosphere floating sensor for targeting applications but the same can be used for location and weather applications or harnessing ocean currents for powering Automated Underwater Drone applications can be used for shipping, submarines or civilian energy generation.

Re-directing Donald’s Joystick

So that in the nature of man, we find three principal causes of quarrel:

First, Competition;

Secondly, Dissidence;

Thirdly, Glory.

The first, maketh men invade for Gain;

the second, for Safety;

and the third, for Reputation.

― Thomas Hobbes, Leviathan

In this article last year (http://poleconomyindia.blogspot.in/2016/04/power-shortage.html), I had pointed out how the global leviathan is realizing it no longer has the power in certain situations and is unwilling in others to enforce rules (whether right or wrong). But, for example, when the electric car has limited power it more important to use that on driving it to the next charging station than anything else.

Post-World War II, US and USSR covered most of the world under their influence, thereby checking regional aspirations. The superpowers fought at the edges of the world in Vietnam, in Middle-East or in Afghanistan but never in the core area of their interest, the European peninsula. This balance of power ensured almost 5 decades of peace. When the Soviet Union collapsed under the burden of arms race and the collapse in oil prices (its principal export), the world was left with one overwhelming super power. But no wars followed given this imbalance because Americans given their endowed lands and the security of the two oceans have not coveted foreign land but influence across the globe and that they did enforce. But then came 9/11 and the great financial crises of 2008. It un-ravelled many underlying glossed over pressures across the globe and created new ones.

In this un-ravelling world it is very important to focus and drive to the next critical destination.

For example, Syria represents an unsolvable proposition for all parties involved but all parties are involved to protect their interests:

• Turkey is involved to ensure the Kurds do not unite across Turkey, Syria and Iraq and, therefore, threaten its stability and Iran does not have an upper hand close to its borders but does not want to get involved in a full-blown fight;
• Iran and Saudi Arabia are fighting for Sunni and Shia dominance, respectively, across the Middle-East and in Syria;
• Russians are involved for nothing but a bargaining chip if the situation arises for quid pro quo in Ukraine and image projection, there is no oil / strategic asset nor is it a bordering state;
• The erstwhile ruling sect of Syria, the Alawaites, are fighting with their back to the wall knowing fully well that they will be slaughtered if they lose;
• Islamic State is fighting to as they state establish a Caliphate somewhat akin to the Turkish empire fell at World War I;
• Israel keeps a tab on anything which can cause potential issues like arms smuggling to Hezbollah by Iran via Syrian territory;
• New York has 42 law enforcement per 10,000 population which is a quiet zone, Iraq has a population ~38m and Syria has ~17m, US could not stabilize Iraq and it does not have the force possible to stabilize Syria. It does not mean that it should not draw redlines for chemical warfare or such acts but it is not in its power to solve this issue.

From a geopolitical perspective, there is no strategic need for the US to intervene in Syria and any other place in the Middle-East in a significant manner unless one power becomes dominant. Unfortunately, the harsh reality is morality may not go a long way, exhaustion will and natural pressure/capacity building by the Turks and Iranians to reach a balance of power will.

There are many countries who have the potential capability to go nuclear and at the level of industrialization South Korea and Japan surely count among them. The only reason they have desisted is due to the American nuclear guarantee. The problem with North Korea is if the US does not “appropriately” deal with the issue, its likely these countries will go nuclear changing the configuration in the region. North Korea has significant concentration of artillery focussed on Seoul and any miscalculation can lead to significant or complete damage to South Korea’s capital where almost 50% of its population lives and this complicates any potential US action. North Korea hopefully realizes that any confirmation or understanding that it is very close to completion of development of its nuclear weapon delivery systems will create an urgent need for action. And, once developed they enforce a high deterrence value. But once they are fired, the threshold is crossed, ensuring obliteration of the regime. The other configuration that changes in the region with the collapse of North Korea is whether the Chinese seek to enforce the current geographical divide as a buffer zone or the Koreas merge changing completely the security calculus of China. It is difficult situation with no perfect answers and nor do I have the intelligence to make the judgment. That the Americans would love if the Japanese could take care of the issue, they hardly want to be the only country in the world in the extreme case to use nuclear weapons and that too twice. It is also true that US has been egging Japan to take a more proactive security role, to that extent changes are being made in the pacifist doctrine. It may not be surprising if the US looks the other way over the next few years to the Japanese developing a nuclear capability were China to continue with its build out or Japan doubts US security guarantees.

Global power moves in cycles. This is, however, not to say Athens, Carthage or Rome will become great global powers again as they existed in a disconnected and undiscovered world. But the ascent is as difficult to manage, as the decline. While Chinese power has been on the ascent and Russian on the decline. As the sole current global superpower, albiet not permanent, US needs to especially manage these players which stand on the other side of the divide, unlike the other European ones, to ensure none emerges as a peer competitor or dominates their part of the globe which allows it “displacement power” in any other part of the world.

Ever since the Nato undertook an expansion eastward in the 1990s, there would come a time when the Russians would not tolerate it. And, it came. For the Russians, who been attacked by Napoleon to Hitler via the Northern European plain, Ukraine was a country which served not only as a critical buffer state with large agricultural and industrial base but also provided access to the Black Sea, the only all-weather port. But in April 2008, Nato summit in Bucharest, the alliance considered admitting Georgia and Ukraine. Georgia was attacked later that year, sending a clear message to the Western Alliance. Then, in 2014 came the overthrow of the pro-Russian regime in Ukraine which as per Moscow was backed by the West. Then followed the crises in Ukraine. The American’s and its allies miscalculated and we are seeing the effect of aggressive Russian actions in Syria and beyond. “The Russians have a lot at stake, and the power of Moscow pride should never be underestimated,” – Bob Schaffer. While Putin announced a military modernization program in 2010, by 2015, the government launched a full-throttle program to finance ambitious military procurement and reinvestment into the defense industries, which are mainly state-owned. On this basis, the production of military products in 2013–15 grew by 15–20 percent annually, and approximately the same growth may continue in 2016. Large part of the Russian economy is structured around material exports, especially oil, 85% of oil price increase between 2005-2014 went to fiscal. The currency has since 2013 declined from 32 to the USD to 56. Russia’s Ministry of Finance says that Russia’s Reserve Fund will be fully depleted by end of 2017 and country will start then using the National Wealth Fund money. The other problem both from a military staffing, economic productivity and strain on fiscal resources is the ratio of taxpayers of working age (paying payroll taxes) to those of pension age (receiving pensions) was 2.5:1 in 2014, according to a Rosstat forecast, it should reach 2:1 by 2030 and worsen. With limited technological modernisation unlike Japan or Germany, declining population will significantly sap the energies of the Russian state. Putin, KGB agent was based in Germany to steal industrial secrets early in his career, surely, understands this and therefore is trying to build a sphere of influence in Eastern Europe and Central Asia not by occupying but by subversion through intelligence assets, buying control of the media or critical energy assets. While the Americans have made their mistake and hopefully understand. Given the state of the conflict, it is unlikely that there will be peace in the near-term. The real pressure point is any build-up on the Northern European plain which projects power into the heartland of Russia, the Moscow region, and the most dynamic and willing country in the area is Poland (see position of the country on the map) to project power. Poland was one of the preeminent powers of Europe in the 18^th century before it as divided by Russia, Prussia and Austria. It has a youthful population, a large economy, geographic position and most importantly the national-will having suffered significantly during the World Wars and post that in the cold war. This is the only game for the Americans to play, rest are pawns on the Russian board to give up as and when they deem fit, including Syria. In the long-term as the Chinese allied with the Americans during the cold war, so may the Russians against China as the power balance deteriorates over time. A stronger neighbour sharing a common border is always a more material threat. In that time, Russia may also integrate more with Europe while becoming socially modern.

China has one simple goal vis-à-vis the Americans – let things continue as they are or worse let Americans be mired more elsewhere so that they do not focus on China. Given China is the biggest and only benefactor of North Korea, just as Trump talked about sanctioning China on trade, North Korea has flared up. Maybe a coincidence!! China’s main social contract with its populace is growth, employment and a fix to national humiliation by western powers and Japan over the since the 19^th century. The most critical element to achieve this is continued high economic growth. China has practically followed the South East Asian Tiger or Japan playbook of ensuring control over national savings to invest in productive capacities to capture international demand. This story continued for almost 3 decades till the Global Financial Crises when its exports fell 8% of GDP. What replaced it was credit propelled infrastructure build, real estate and expansion in related industrial capacities like steel and glass. Out of the 43 countries currently measured by BIS, China has the largest credit-to GDP gap at 30% of GDP. This is equivalent to US$3.1trillion of excess credit. For 15 years prior to 2009, China’s Incremental Capital Output Ratio was consistently between 2 and 4 which means for every 2 - 4 yuan of fixed investment one yuan of GDP was created and now it is over 13. In 1Q 2017 China expanded credit by almost 7 trillion renminbi or $1trillion helping them generate an annualized 6.9% GDP growth. I had highlighted these excesses in my article in 2015 and 2017 (http://poleconomyindia.blogspot.in/2015/08/china-everything-overdone.html and http://poleconomyindia.blogspot.in/2017/01/stimulus-and-protectionism.html). Given that China is a closed economy with the government owing the banks it may be able to manage the disequilibrium without sparking a major international crisis, like Japan or Thailand, but surely growth will be much lower. In its recent push to create national champions in new age industries and to also capture its internal demand, it is creating unequal rules for market access. For example, it is requiring global technology companies to hand over encryption to local agencies. In 2016 Apple’s iBooks Store and iTunes movies were shut 6 months after they started or in cloud computing it mandates foreign companies to work with local partners and can only have a minority stake while Chinese companies operate cloud services in the US. Not only will the next phase of Chinese economic adjustment require massive changes in the composition and level of growth, it also needs peace and tranquillity. For all that has been said about the Chinese military and international power in the press, it does not participate in major international issues like the Middle East. It would prefer to keep away and not share the international burden. It also makes it therefore afraid of both economic and military actions of the US which may draw it in. Like Thucydides said of the Athenians at the height of their power, “In other ways, too, the Athenians were no longer as popular as they used to be: they bore more than their share of actual fighting, but this made it all easier for them to force back into alliance any state that wanted to leave it.”

China is a country in transition where President Xi is consolidating his power, more than any leader since Mao, to effect changes to its economy and military. We will see of a lot of sensitivity and nationalism during this period – American deployment of THAAD in South Korea, Dalai Lama visit to Tawang, Vietnamese oil exploration in the South China Sea. The economy is China’s Achilles heel and this is where the Americans need to focus to change the unequal market access, intellectual property rights and trade levies. It’s an economy already in disequilibrium, pressure from export markets will cause significant deterioration and consequently impact military build-up and China’s leverage with regional economies. It is important to understand in China the Communist Party has a state rather than a state having a party and that party always feels threatened if the basic social contract frays – the rising industrial and environmental problems, difficulty in employment and income growth, negative sentiment in the elite taking out money from the country resulting in the central bank putting draconian restrictions.

Zbigniew Brzezinski in The Grand Chessboard points out,” In brief, for the United States, Eurasian geo-strategy involves the purposeful management of geo-strategically dynamic states and the careful handling of geopolitically catalytic states, in keeping with the twin interests of America in the short-term: preservation of its unique global power and in the long-run transformation of it into increasingly institutionalized global cooperation. To put it in a terminology that hearkens back to the more brutal age of ancient empires, the three grand imperatives of imperial geo-strategy are to prevent collusion and maintain security dependence among the vassals, to keep tributaries pliant and protected, and to keep the barbarians from coming together.”

America is the first and only truly global power and unfortunately institutionally power is not that easy to disavow even if one joystick points in the wrong direction or continuously fires in many directions.

“If you lose direction, go to a higher ground.” 

― Toba Beta, My Ancestor Was an Ancient Astronaut

Tax, Tax and More Tax

“This is a question too difficult for a mathematician. It should be asked of a philosopher"(when asked about completing his income tax form)” ― Albert Einstein

India is embarking on a breath-taking change in its tax regime, collapsing excise duty, countervailing duty and service tax, as also state levies like value added tax, octroi and entry tax, luxury tax. The intent is threefold:

• Make India a single-market removing the various infrastructure bottlenecks like multiple distribution hubs or stopping at state check-posts;
• Incentivize formalization of the economy (as buyer will not get tax credit if the supplier does not pay his tax);
• Up the effective Tax to GDP (see data table below) of the economy to allow higher spends on defense, social security and infrastructure - despite high corporate tax rate we have very low tax realization, although it is also because a large part of wealthy farmer population is taxed at Zero.

Now for the complication:

• Each entity is required to file 3 returns a month, 1 every quarter and 1 annually so that’s 41 and these are completely new forms;
• If a company is having four branches in four different states, all the four branches will be considered as a taxable person under each jurisdiction of state government, given they need to get credit for activities terminating in their state same returns have to be filed;
• Earlier certain services were not covered under VAT, ERP’s need to change to catch these transaction;
• Re-working of ERP’s and related incremental connectors / API is almost akin to a mini Y2K;
• Finally, if one does account for the taxes due even suppliers not filing matching tax credits, there are penalties and pay more you loose working capital.

So, the limited point is its going to be some serious work to get the new system implemented.

The single point agenda that the government seeks to address is enhance the tax to GDP ratio. For example, India’s defense to GDP is 2.4% or ~US$50bn, the strategic community believes that getting to US$100bn addresses Pakistan and 2x of that would make India China’s peer. Also, the push to indigenize and grow defense manufacturing to such volumes will have a positive effect on overall growth.

New tax to correct global trade imbalance

The massive global imbalance in savings and investment across countries have been at the heart of the global economic problem. These excessive savings generated in countries like China, Germany and Japan have to be absorbed and the largest country absorbing these savings is the US, despite productive capacities not growing at such pace. These excessive savings are absorbed in the form of foreign direct investment or portfolio flows. Open regimes like US, Canada or Australia have limited restrictions on capital flow, this excessive savings flow have three impacts:

• reducing interest rate;
• increasing exchange rates; and
• higher property prices.

This also manifests itself in art valuation or capital available for start-ups. Lower interest rate, cheaper goods via higher exchange rates and home equity from higher property prices enable higher imported consumption. Capital flows, consequently, is at the heart of the global imbalance.

Let’s take an example:

• Assume China and US are only two countries in the world. China exports 100 and imports 80 from US;
• In a growing economy like India, this deficit would have led to larger proportion of FDI in domestic factories or productive infrastructure than incremental debt or asset sales, matching the forex outflows;
• US is a very developed economy with trend growth of under 2% and consequently unable to absorb investment in productive assets like infrastructure or factories at a very high rate without government intervention (which is what Trump wants to do) and China has already built the assets required to support US consumption;
• This deficit consequently will now be funded via import of capital from China either into more debt or via sale of US assets;
• This has the effect as I mentioned above of reducing interest rate, increasing exchange rates and higher property prices and limited expansion in productive capacities so limited job growth;
• This in summary has been the story of the world for over a decade - Public debt and property prices (The US also had the best of the growth, increasing its hold on the list with 15 of the top 25 cities - Cushman and Wakefield) have risen while likes of Starbucks provide part-time employment which is taken to count employment levels.     

	Corp Tax Rate (%)	Tax Burden (%)	FDI Inflow (bn)	Public Debt (%)	Property Price since 2010
US	35	26	380	106	31.9%
China	25	19	136	44
Japan	24	30	(2)	248	9.2%
Germany	16	36	32	71	26.4%
Australia	30	28	22	37	36.1%
Canada	15	31	49	92	47.7%
UK	20	33	40	89	29.1%
Italy	28	44	20	133	-15.4%
Turkey	20	29	17	33
Mexico	30	20	30	54
India	35	17	44	67

Source: Heritage Foundation, BIS

Globally savings is equal to investment and difference between savings and investment in a country manifests in the form of trade difference (or import and export difference). Until the global economies begun to address the problem of capital flows, one side of the equation, trade imbalances will not adjust. The alternative is automatic system forced correction like the decline in southern European (like Italy) import is having on German industry or the sharp recession in Japan in the 1990s. The suppliers of these savings like Germany or China do not want to make the systemic changes, the receivers (i.e. US, UK or Australia) may have no choice but taxing such unwanted capital flows (i.e. residential property) to not only reduce the trade imbalance but also start pruning the very high levels of debt.  

“There is no worse tyranny than to force a man to pay for what he does not want merely because you think it would be good for him.” ― Robert A. Heinlein, The Moon is a Harsh Mistress