Jody Bottum calls my attention to an astonishing post by attorney Kenneth Anderson over at the Volokh Conspiracy. After the Obama administration shredded bondholder rights in the Chrysler and General Motors bankruptcies, the rule of law in the United States now is on par with China’s. Anderson writes,
As I watch the Detroit restructurings unfold, particularly the strong-arming of senior and secured creditors, I wonder what new covenants creditors might want to put into new bond issuances by US businesses that might eventually become entangled with government...the general assumption is that no political risk covenant can really protect you in a place where contracts are not enforced political risk of that kind involves yanking the floor out from under the investor altogether. If a contract term that provides for secured creditor status will not be enforced, why think that a covenant requiring repayment in case of political risk such as expropriation will be enforced either? The nature of political risk is that it is a risk running to the very rules of the game.
In a number of locations, including my “Inner Workings” financial blog, I accused the administration of turning the US into a banana republic. That’s not true, of course, Anderson writes. There is some rule of law in the US, sort of, but it’s shaky and subject to change. It less resembles a banana republic than, say, China.
Of course that is not completely true. There are political risks and there are political risks, if you are investing in the developing world or, alas, today the United States. The United States seems, in these contract matters, not to resemble the rule of law in Angola, sure but it is distinctly starting to resemble, ever so little-bit-by-little-bit, the rule of law in China. There is a certain amount of neutral contract enforcement, but also a hefty amount of political thumb on the scale, and many uncertainties attached and without getting hysterical about it, the American trend line is going that direction. It might be most useful to look at Western contracts with Chinese companies to get good ideas on “mixed” cases of this ‘sort-of-rule-of-law, sort-of-not’, because that seems to be the drift of Obama administration industrial policy.
This is an astonishing statement, and a momentous one. Chinese technical types and entrepreneurs came to the US (along with their Indian and other counterparts) during the 1980s and 1990s precisely because the rule of law prevailed in the United States. In the US, you could set up a company, float stock, file a patent, and count on the courts to protect you. Asian immigrants comprised nearly half the skilled workforce in Silicon Valley during the peak of the tech boom.
Why should Chinese and Indians leave family, friends and culture and come to the US today?
1) Local capital markets are robust and outperforming the US market by a huge margin;
2) Venture capital is available for startups;
3) The local banks are in better shape;
4) It’s harder to get into the US, thanks to post 9/11 security regulations designed not to offend Arabs by making it tougher on everyone; and
5) America’s decisive advantage, the rule of law, has disappeared.
If the rule of law in the US is no better than China, just what do immigrants expect to find in America? Capital? Infrastructure? Inexpensive skilled labor? Well-trained university graduates? An expanding internal market?
Kenneth Anderson finds it “shocking” that American investors now ask his advice based on his extensive experience in designing contracts for investments in third world countries:
Something I have sometimes negotiated into developing world debt covenants is a political risk form of a poison put. It is merely a standard poison put, used to address changes of corporate control, adapted to political risk. Nothing special. It simply says that if certain political contingencies occur, such as a government (or union) move to take direct or indirect control of the borrower-corporation, the creditor bondholders can at their option put the bonds back to the corporation and require full repayment of principal, and whatever is negotiated for interest and penalties. It is a response to this particular political risk, not of full-blown rule of law breakdown but instead of what might be under local law a legal move by the government. It allocates the risk and presumably gives the borrower-corporation some incentive not to seek government involvement.
I haven’t inserted it often, and have never even thought about trying to enforce it (Montenegro or Macedonia? Zimbabwe? Indonesia?). Is this kind of political risk poison put worth using in future American corporate bonds? Or is it ‘a little bit pregnant’ and no matter what you wrote in the poison put, it would be subject to the same political re-writing? After all, though I haven’t looked, isn’t it likely that Detroit’s existing bonds have change of control provisions anyway? Leaving aside its practical effect (or not), what about the effect on the interest rate? Would this be likely to reduce the uncertainties and so reduce the interest rate for risk? Or is it a mostly futile exercise?
(And I have to say, the idea that I would ever be publicly airing such a question about leading US corporations and the bond market, looking to my experiences in the developing world for counsel and advice is, well, shocking.)
Sadly, I would advise investors to look to Asia rather than to America for returns during the next generation. As I wrote at “Inner Workings” last week,
Wealth comes from sweat and smarts. Here’s factoid for you: China has 60 million elementary and secondary school students studying piano or orchestral instruments and playing classical music. America has 30 million students, total. China has classical music students at twice the number of all American students waiting in the pipeline to join the job market. Add to these the smart Indian kids who will be graduating from India’s technical institutes with the world’s sharpest math skills, and it seems likely that during the next five or ten years, a good 75% of the best-qualified job market entrants will come from China and India.
I cite the classical music students in order to emphasize that we are not talking about robotic nerds who know how to crunch numbers but have no creative ability. A “Spengler” essay from last Decemberprovides some detail. Anyone who has not been hiring young Asians has no clue how cultured and curious they are. Their American counterparts have seen life as a perpetual spring break interrupted by brief episodes of work, and are simply in no shape to compete.
In past years, to be sure, the smartest Asians came to America. That’s where the capital markets were. A rich Chinese wouldn’t lend money to a poor Chinese, unless the poor Chinese first moved to America. Our financial system was the glory of the world. That was then. If you are a smart Chinese or Indian entrepreneur, are you likely to get richer by moving to the US or by staying at home? Emerging market equities are a far more interesting proposition than the US stock market under Emperor Obama I. Bonus restrictions? Compensation caps? They never heard of them in Mumbai or Shanghai.
America isn’t getting the immigrants any more, that is, the top-of-the-line human capital. As China reorients its economy towards domestic spending, America won’t get the capital, either. America isn’t going to crash. Unless it changes course, it will slowly sink into the mud, like England did during the 20th century.
Equity investment is worth considering in China and India. China’s doing a great job of providing a serious stimulus, and India’s Congress Party victory puts a very qualified Prime Minister into power. It’s a snooze here in the Republic of Zombies.