Financial Times Europe - 31.07.2019

(Axel Boer) #1
Wednesday31 July 2019 ★ FINANCIAL TIMES 9



opes that the resumption
of trade talks between the
US and China will liftthe
shadow of uncertainty
hanging over the world
economy miss something fundamental.
Restoring global value chains, rebalanc-
ing US-China trade and increasing pro-
tection for intellectual property are, of
course, desirable objectives. But there is
a more significant issue at stake: loop-
holes in global trade rules on subsidies
and the absence ofany agreed restraints
on state-owned enterprises.
China’s “Made in China 2025” pro-
gramme is designed to turn the country
into a “leading manufacturing power”
in 10 key industrial sectors by 2049.
This is state support for industry on an
unprecedented scale.
Western companies and governments
do not have access to basic facts about
Made in China 2025 because that infor-
mation is buried in unpublished govern-
ment budgets and shieldedas “state
secrets”. Although existing global trade
ruleson subsidies permit challenges to
such programmes, the latter will fail in
the absence of evidence.
Similarly,too little is known about the
100,000 SOEs that produce one-third of
China’s gross domestic product and pro-
vide one-fifth of all its jobs. How much
government funding do they receive?
How extensive is government owner-
ship? What positions are occupied by
government officials?
Beyond domestic support, China’s
trade policies shelter SOEs from foreign
competition. For example, Chinese
makers of electric vehicles must use
batteries made in China rather than

import them from Japan or South
Korea. Meanwhile, foreign brands have
a small presence in theChinese EV mar-
ket, with a share of about 5 per cent.
Because SOEs are relative newcomers
to the global economy, there are few
trade rules to restrain them. Neverthe-
less the major developed economies still
have substantial leverage and are
exploringways to use it.
For instance,the trade ministers of
the US, EU and Japan hare profounds
concerns about China’smodel of state
capitalism. They and their staffs have
met six times since December 2017 to
discuss a joint effort to strengthen sub-
sidy rules and establish new rules gov-
erning SOEs. However, US president
Donald Trump’s insistence on negotiat-
ing his own deal with China means their
efforts have so far attracted little politi-
cal support in Washington.
This “trilateral” group is discussing
incentives to encourage China, and
other World Trade Organization mem-
bers, to comply with the existing rule
that all countries must disclose full
details about their subsidies. They are
also onsidering possible penalties forc
A recentruling y the WTOb has
strengthened the trade ministers’
attempts to establish that an SOE is a
“public body” if it is majority-owned by
its government, a position China has
resisted. WTO rules define a “subsidy”
as a financial contribution made by “a
public body”.
Another issue is China’s use of forced
technology transfer. Here, the trade
ministers’ group is considering a range
of measures, including limits on Chinese
laws which force foreign companies to
enter joint ventures.
The WTO operates on aconsensus
basis, which means that a single mem-
ber can block reforms. So China will
have to be persuaded that it should go
along with the measures being pro-
posed. In the past, it hasdone so hen aw
large number of countries has sup-
ported new measures. It is a good sign,
therefore, that the trilateral group is
expanding to include Australia, New
Zealand, Canada and Mexico.
It is unlikely that the US-China trade
talks will address subsidies and SOEs. So
the deliberations of the trilateral group
are our best hope of taming China’s
rogue state capitalism. The Trump
administration should get behind them.

The writer, who practised international
trade law, is a senior fellow at the Center for
Study of the Presidency and Congress

How to

tame China’s

rogue state



Western powers lack
ccess to basic factsa

bout Beijing’sa

industrial subsidies

many of which are owned by pension
funds. But future returns are likely
to fall. The result will force workers to
accept some combination of later retire-
ment, higher taxes, bigger pension con-
tributions or lower incomes in old age.
It is possible that this bout of low
interest rates will end. Perhaps the Fed
is mistaken and it will have to raise rates
sharply in the future. Perhaps a burst of
technological progress will raise growth
and boost demand for capital.
But no one can choose to make that
happen: this is not some perverse plot
by Fed chair Jay Powell and ECB presi-
dent Mario Draghi to make life misera-
ble for the world’s savers. The long-run
real interest rate balances the desire to
save and demand to invest. Central
banks are its servants not its masters.
The trend towards lower real interest
rates has lasted for decades and is as
likely to continue as to reverse. With
central banks moving to ease, it is time
to stop waiting for rates to recover and
face the world as we find it.

A monopoly supplier of water or elec-
tricity, land in a city centre or the back
catalogue of Disney: the capital value of
these assets must rise, so their yield
matches the lower interest rates. This
trend is related to recent movements in
wealth inequality. It also puts investors
at risk of identifying financial bubbles
that do not actually exist. One vital
policy response would be to slash the
return on capital allowed to utilities.
Seventh, demand for housing will
rise. It is, after all, the main capital asset
that most people use. There are two
potential outcomes. Where it is possible
to build, permanently lower interest
rates will trigger an increase in the hous-
ing stock. If it is not possible to build,
then houses will behave like assets in
fixed supply, and soar in price. Thus fall-
ing interest rates make planning and
zoning rules a crucial economic issue.
Eighth, low interest rates make it
harder to save. In particular, they make
it harder to save for a pension and
harder to live off whatever capital accu-
mulates. This fact has been obscured by
the one-off rise in price for scarce assets,

debt more sustainable. This is particu-
larly true for public debt, because coun-
tries actually borrow at these low risk-
free rates, and somewhat true for pri-
vate debt. For many countries, it makes
sense to borrow more in order to invest.
Predictions of financial crisis based on
past levels ofdebt-to-gross domestic
product re likely to be misleading.a
Fifth, capital stock should rise relative
to output. Investments that were once
unprofitable now make sense: road
upgrades to save a few minutes of time;
expensive, niche drugs to help a few
hundred people; or extra years of study
to earn a graduate degree. Such projects
may feel irrational. They are not.
Sixth, any asset in fixed supply is now
more valuable, because its future cash
flows can be discounted at a lower rate.

Although interest rates touch almost
every aspect of economic life, the devel-
oped world remains deep in denial
about the consequences. Here are eight
themes for investors and policymakers
to ponder.
First, there is an intimate link
between long-run interest rates and
long-run economic growth. Perhaps
capital is less relevant to the digital
economy, but forrates topeak at such
low levels sendsalarming signals about
the prospects for future expansion.
Second, monetary policy is broken. In
2008-09, the Fed cut rates by 5 percent-
age points and it was not enough. Today
it has far less room to respond to a reces-
sion. The Bank of Japan, whichmade no
move on Tuesday, has all but given up
trying to hit its 2 per cent inflation tar-
get. The ECB is in danger of going the
same way. The world is dismally unpre-
pared for a downturn: two of the world’s
most influential central banks may start
the next recession with their policy rate
already below zero.
Third, if monetary policy is broken,
fiscal policy must step in. That means
either governments must approve
higher spending and tax cuts in
response to a recession or else give the
central bank a fiscal tool in the form of
“helicopter money”, essentially printing
money to spend or distribute to the pub-
lic. Alternatively, governments could
set higher inflation targets and use fiscal
policy to reach them now. That would
give their central banksmore room to
cut when they need it.
Fourth, lower interest rates make


his will be a discomforting,
defining week for the global
economy. That is not
because the US Federal
Reserve is set to cut interest
rates. Rather it is because of the strik-
ingly low level of rates from which
the Fed will start: a range of just 2.25 to
2.5 per cent.
After more than a decade of economic
expansion, and despite everything from
tariffs to tax cuts, it seems this is as high
as US interest rates go. Meanwhile, the
European Central Bank is debating
whether to reduce its negative rate still
further. Until this month, it was possible
to imagine that pre-financial crisis lev-
els of 4 to 5 per cent might eventually
return. No longer.
According to their own projections,
Fed officials believe rates willsettle at
2.5 per cent n the long run. Subtracti
their 2 per cent inflation target and the
real reward for capital is going to be a
miserable 0.5 per cent. The equivalent
rate in Europe and Japan will almost
certainly be much lower. Such low levels
of interest rates are a profound change
from the past. (The federal funds rate
was 6.5 per cent, and the real rate was
about 4 per cent as recently as 2000.)

Profoundly low

interest rates

are here to stay

Rising asset prices put
investors at risk of

identifying financial

bubbles that do not exist


henever big companies
crash and burn — Enron
in 2001, banks in 2008,
Carillion last year —
investors invariably
demand, ‘Where were the auditors and
why didn’t they warn us?
The Big Four auditors — PwC, KPMG,
Deloitte and EY — equally invariably
respond that investors and politicians
have unrealistic expectations about
what auditors do, given how much
money and time they are given to do
their work.
That did not stop the US from tighten-
ing the rules in the 2002 Sarbanes-
Oxley corporate accountability act,
including mandatory audits of internal
controls. Companies and auditors

complained bitterly about the costs of
European bank failures in the finan-
cial crisis sparkeda further spate of new
rules, and now the Carillion collapse has
prompted the UK to considergoing fur-
ther still nd forcing firms to split audit-a
ing from consulting. Concerns about ris-
ing costs are already starting to roll in.
This month EYsent letters o all of itst
FTSE 350 clients warning that it would
be boosting its audit fees due to
“unprecedented market forces”, while
KPMG isscaling back its exposureto the
building society sector partly out of con-
cerns that smaller lenders cannot afford
to pay for theadditional work that now
needs to be done.
Auditors say there are three main
drivers of higher fees. First, the EU
decided to require companies to tender
their audits once a decade and change
auditors at least every 20 years. Tender-
ing and getting to know a new client
adds costs, and shorter contracts mean
investments in new people and technol-
ogy cannot be spread over many years.
Second, UK regulators and inter-

national accounting standards setters
are demanding that auditors up their
game by providing more sophisticated
modelling of risks, as well as more docu-
mentation of what they have done to
challenge management assumptions.
Third, if firms do have to split audit-
ing and consulting, they must ensure
audit businesses are profitable on their
own, rather than being loss-leaders for
the larger firm.

Most of the Big Four firms, and Grant
Thornton, which is number five, have
announced or carried out big hiring
pushes as they seek to bulk up on expe-
rienced auditors and modelling experts,
as well as invest in artificial intelligence
and machine learning
At EY, that has led to the letters

warning of higher fees. Head of audit
Hywel Ball explains that the increases
“reflect the significant investments we
have already made in new technology,
regulatory compliance and talent, plus
recognising the tendering and switching
costs. This is about delivering sustaina-
ble, high-quality audits.”
KPMG is not sending out formal let-
ters, but it is warning clients about the
cost impact of tougher standards and
rethinking its fees. The firm, which used
to audit half of all UK building societies,
has dropped about a dozen clients in the
sector. Part of this is due to mandatory
rotation, but there is also a financial
motive. “We are making sure that we are
getting paid appropriately when more
work is done,” says Michelle Hinchcliffe,
who heads audit at KPMG.
As the UK government gears up for a
further crackdown, it is worth asking
whether companies and investors are
getting their money’s worth from what
has already been done.
In the US, once teething problems
were sorted out, Sarbanes-Oxley
became just another part of the

regulatory landscape. And a 2017 study
found that companies identified by
auditors as having weak internal
controls were80 per cent more likely ot
have a future fraud revelation.
In the UK, the auditor rotation rules
are having an impact. PwC calculates
that 287 of FTSE 350 companies have
tendered their audits since 2012, and
73 per cent of those have changed pro-
viders. It is too soon to tell whether fresh
eyes will lead to better audits in Europe,
but American studies have found that
companies with new auditors havesig-
nificantly higher restatement rates hant
those who stayed with the same firm.
The UK needs auditors with back-
bone, who are willing to stand up to even
the most difficult managers. Grant
Thornton has made a start by telling
regulators thatit plans to quit s Sportsa
Direct’s auditor after the retailer
revealed a €674m tax bill just hours
before the accounts were due to be
signed off. If that costs a bit more, it
would be well worth it.

Businesses worried about
the expense of new

regulations should

remember quality is key

Higher audit costs are a price worth paying


here has been much written
lately about imposing an
explicit wealthtax, as well
as higher income taxes, on
the richest Americans.
Several Democratic presidential
contenders, most notably Elizabeth
Warren, have called for a wealth tax and
it has been embraced bymore than a
few members of the very group that
would be hit hardest by such alevy.
Proponentssuch as George Soros,
Chris Hughes andAbigail Disneyargue
that such a tax could raise trillions of
dollars over a decade, money that might
be used to address myriad social chal-
lenges such as climate change, crum-
bling infrastructure, student loan debt
relief, structural poverty and universal
childcare. They claim in an open letter
that a wealth tax is patriotic and would
strengthen our democratic freedoms,
and that rguments against the tax “a are

mostly technical and often overstated”.
As a taxpaying American business-
man with more than a passing familiar-
ity with the ways of Washington,I dis-
agree. I question whetheran explicit
wealth tax is the best path forward orf
the country and whether the federal
government is currently up to the task
of allocating those tax resources effi-
While I have been richly rewarded by
a life of hard work combined with oodg
luck, I was not to the manor born. My
father was a plumberin the South Bronx
after migrating from Poland. I bene-e
fited from a good public education sys-
temand my parents’ constant prodding,
becoming the first in my family to earn a
college degree. When I joined Goldman
Sachs, I had no savings, a negative net
worth, astudent loan, and a six-month-
old baby (not to mention his mother,
my wife of now 55 years) to support.
After a successfulrun at Goldman, I
started a private investment firm. As a
result of my good fortune, I have been
able to give away to those less blessed
far, far more than I have spent on myself
and my family over a lifetime, and I
have joinedWarren Buffett and Bill

Gates inpledging that the majority of
my money will continue to do some
good after I’m gone.I know many peo-
ple who are similarly situated, by both
humble origin and hard-won accom-
plishment.We feel privileged to be able
to give, and we do. My parents would
have expected nothing less.
The history of explicit, annual wealth
taxes, as distinct fromone-time estate

taxes, has not been salutary. IMF execu-
tives James Brumby and Michael Keen
found that among OECD countries, the
number with an active wealth tax
dropped from 12 to four between 1985
and 2007. They also warned that such
taxes were “of limited effective-
ness. .[and] notoriously prone to lob-.
bying and the granting of exemptions
that the wealthiest can exploit”.
Why should we expect a different out-

come here? It would be more construc-
tiveto eliminate government waste,
redirect existing resources tosocial exi-
gencies and remove biases built into the
tax code that frustrate the objective that
everyone pay their “fair share”.
Some wealthy business owners
largely avoid paying income taxes by
taking very little out of their companies
in the form of salary or dividends and
sitting on massive unrealised gains in
their stock that can then be bequeathed
to charity with no tax ever being paid.
Closing that loophole would help under-
write even some of the most ambitious
legislative programmes.
I believe in a progressive income tax
structure — the wealthyshould ayp
more. But at some point, the effective
tax rate (federal, state and local rates
combined) becomes confiscatory. That
never has been, and in my view never
should be, the American ethos.
Personally, Idon’t mind working six
months of the year for the government
and six months for myself, paying a
combined tax rate of 50 per cent on my
income (in some US cities that effective
rate is even higher),but many of the
nation’s highest earners pay far less.

Rather than enact an explicit wealth
tax whose efficacy has been debunked
worldwide, Congress should revisit the
“Buffett rule”, named for his belief that
the wealthy should not pay a smaller
percentage of their income in taxes than
those who are less affluent, and impose
a surtax on those making more than
$1m. The combined effective tax rate
still should not exceed 50 per cent.
But before levying more taxes of any
stripe, presidential candidatesshould
commit to trying to fund their agendas
by culling bureaucratic waste. Right
now, I don’t have much faith that Wash-
ington can be relied upon to spend new
tax revenues fficiently.e Frustrated
efforts to privatise the US Postal Service,
which lostnearly $4bn n itsi latest fiscal
year, are a good case in point.
I know that cut-the-bloat doesn’t fire
up the Democratic political base the
way soak-the-rich does, but it would go
a long way to closing the looming budg-
etary gap and make any later proposals
to raise taxes a lot more credible and

The writer is chief executive and chairman
of Omega Family Office

It would be better to
eliminate government

waste and loopholes

for high earners

A wealth tax will not solve US inequality







JULY 31 2019 Section:Features Time: 7/201930/ - 18:18 User:alistair.hayes Page Name:COMMENT USA, Part,Page,Edition:USA , 9, 1






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