National Security

Red Line, Green Light

Are we ready for the coming Iranian terror wave?

Israeli Prime Minister Benjamin Netanyahu’s call for the United States to declare “red lines” for Iran and its nuclear program makes it even harder for the Obama administration to walk the line between calming Israel and increasing the pressure on Iran. As Washington considers its responses -- and anticipates how Iran would respond in turn -- the risk of terrorism will loom large for both Israel and the United States.

Terrorism related to Iran’s nuclear program has already begun. Indeed, perhaps the most surprising aspect of the suspected Iranian-orchestrated terrorist attack in July that killed five Israelis and a local bus driver in Bulgaria is that it generated little surprise or reaction in Israel. Israel's former national security advisor, Uzi Arad, pointed out that Iran was simply responding to Israel's covert campaign against Tehran: "Anybody with eyes in their head can see we are in the middle of an escalation orchestrated by various elements, and where occasionally, we are the instigating side." 

This "shadow war" between Israel and Iran has created an escalatory dynamic as the Bulgaria attack indicates, with Iran feeling compelled to respond to what it sees as Israeli aggression. Although specifics are steeped in secrecy, Israel is blamed (or lauded, depending on where you stand) for killing Iranian nuclear scientists, sabotaging an Iranian missile facility, releasing a computer virus that crippled Iranian centrifuges, and killing noted terrorist Imad Mughniyeh, the Hezbollah operations commander who worked closely with Tehran and who was responsible for the deaths of hundreds of Americans when Hezbollah bombed the U.S. Embassy in Beirut and U.S. Marine Barracks in 1983.    

Terrorism, well before Bulgaria, was Iran's response to such Israeli actions. In 2012 alone, Iran has been linked to attempted attacks in Azerbaijan, Cyprus, Georgia, India, Kenya, and Thailand. In October 2011 the United States disrupted a plot to kill the Saudi ambassador in Washington by bombing the restaurant where he often ate lunch. Had the bomb gone off as planned, it would have killed many Americans dining there, too. The question, therefore, is not whether Iran will respond to further provocation -- including the ultimate provocation of air strikes on its nuclear facilities -- but how, and whether Iran's response should alter the U.S. and Israeli calculus.

In considering this question, it's important to realize that terrorism is both Iran's best option for striking back and its only one. When they feel under assault, Iran's leaders want to prove to their population that they are fighting back. The regime is sensitive to any humiliation and has a strong belief in revenge. Anger is particularly intense within key elite audiences (particularly the Islamic Revolutionary Guard Corps, which both protects the regime against domestic opponents and leads its covert operations abroad). Perhaps most important, for all its bluster, Iran is a weak country: its conventional military forces are poorly armed and weakly trained. Economically, Iran is reeling from increasingly tight sanctions, and its ideology holds little appeal -- even in Iran itself. Iran, however, has developed a robust intelligence and paramilitary apparatus, and in the past it has conducted or attempted attacks, at times with its ally the Lebanese Hezbollah, in Europe, Asia, Latin America, and Africa, as well as the Middle East. For Iran, terrorism works.

So, if Israel or the United States took the war out of the shadows and conducted a direct military strike on Iran's suspected nuclear facilities, the Iranian terrorist response would be considerable. We could expect terrorist attacks around the world -- Iran and Hezbollah have shown a presence on every inhabited continent. In addition, Iran would be particularly likely to step up support for anti-U.S. forces in Afghanistan and elsewhere in its neighborhood. Tehran would also use the limited al Qaeda presence in Iran and its ties to Sunni jihadists to try to strike the United States and its allies: the relationship is troubled, but Iran has influence over al Qaeda, and now would be the time for Tehran to call in favors. The scope and scale of the response would depend on the level of casualties from any attack and the political circumstances of the regime in Tehran at the time the attack occurred. An attack that caused many Iranian casualties and was proven to be successful (and thus embarrassing for Iran's leaders), particularly if it came at a time when the Iranian regime felt politically weak, could lead to terrorist attacks on U.S. and Israeli facilities and personnel around the world, including on U.S. soil. 

Still, the threat of U.S. retaliation for such retaliation would make Iran's leaders careful not to let escalation get out of hand. America's conventional might has long moderated Iran's behavior because Tehran knows its forces are no match for those of the United States. Iran toned down its anti-U.S. terrorism after orchestrating the 1996 Khobar Towers bombing. The quite real specter of a U.S. military strike and more comprehensive sanctions probably sobered Iran's leaders.

That could change, however, if Iran acquired a nuclear weapon. Some scholars have argued the theoretical point that, in general, nuclear weapons make states more cautious as they fear the catastrophic escalation that a nuclear crisis could bring. More likely, though hardly inevitable, is that Tehran might become emboldened by a nuclear weapon since it would then have the ability to threaten a devastating response should it be attacked with conventional forces. This "umbrella" would then enable Iran to be more aggressive supporting substate groups like Hezbollah or opposition forces against various Arab enemies.

This is not just conjecture. After acquiring a nuclear capability, Islamabad believed it had obtained a degree of immunity from India's superior conventional forces, and Pakistani leaders began more aggressively supporting various groups in Kashmir and against New Delhi in general. Pakistan even carried out its own military operations in conjunction with Kashmiri fighters against India in 1999, when it seized border posts in Kargil on the Indian side of the Line of Control, almost provoking a major war. Islamabad has also backed groups tied to horrific terrorist attacks in India, including a 2001 strike on the Indian parliament and strikes in Mumbai that killed over 160 people in 2008.

The silver lining is that Iran is not likely to pass a nuclear weapon to terrorist groups except under the most extreme circumstances -- too much could go too wrong in too many ways. Even an emboldened Tehran would recognize that the United States and Israel would see such a transfer as a grave threat (something U.S. rhetoric has repeatedly emphasized) and would dramatically escalate their pressure on Iran, perhaps including significant military operations. In addition, they might be able to gain international support because almost all states, including China and Russia, fear such transfers. Tehran has not transferred much less lethal and controversial chemical weapons to Hezbollah, despite having had such weapons in its arsenal for over 25 years. Groups like Hezbollah would fear the consequences of going nuclear, recognizing that this could lead the United States, Israel, and others to take military action that could threaten its position in Lebanon. In addition, these groups have proven quite capable in using rockets, explosives, and small arms to achieve their objectives.

However, should the clerical regime believe itself to be facing an imminent threat of regime change from the United States and its allies -- a situation comparable to what Saddam Hussein faced in 2003, say -- then the calculus would change dramatically. If the United States deployed ground forces in large numbers or used airpower to back Iranian rebels -- measures that for now are not on the table -- Iranian leaders would see this as a grave threat to their hold on power. From Tehran's point of view, the United States and others would have already escalated beyond the point of no return. Tehran would have nothing to lose, and at least a chance of intimidating or deterring the United States, by such transfers. In addition, Iranian leaders might want revenge or simply want to vent their rage and use terrorists to do so.

Even if the most provocative measures against Iran's nuclear program are taken by Israel alone, the United States should expect to find itself the target of attacks, particularly abroad. Although the two countries do not march in lockstep, the subtle distinctions in Iran policy that divide Washington and Jerusalem are often lost in Tehran. U.S. support for aggressive sanctions and Israel's covert campaign are considered part of a shared effort to undermine the Islamic Republic, and reportedly joint operations like the computer virus that targeted Iran's nuclear program further blur differences.

There is a damned-if-you-do, damned-if-you-don't quality to any policy response to the terrorism threat related to Iran's nuclear program. The Iranian terrorist threat is here to stay -- and, indeed, may be likely to grow -- as the confrontation over Iran's nuclear program reaches a boiling point. Further ramping up intelligence efforts against Iran, working with allied services to disrupt potential plots, pushing to decrease the size of Iranian embassies given the sizable intelligence presence there, and other low-profile measures are obvious steps. But in the end, Iran's lack of strategic options and desire to respond to what it sees as foreign aggression will lead Tehran to continue to work with a range of terrorist groups. Successful U.S. policy can reduce the scope and scale of Iranian violence, but it is not likely to end it altogether. So while we should celebrate efforts to set back Iran's nuclear program, we should brace ourselves for Iran's determination to make us pay a price for our efforts. 



Why China Will Never Have a Wall Street

In good times and bad, Chinese stock markets don’t work. And that's just the way Beijing wants it.

As growth in the United States slows and many European countries head into negative territory, the eyes of the world's investors are on the next big shoe to drop: Will China, the recent engine of the global economy, fulfill its role of Great Eastern Hope by saving the world from another sharp recession? Given its track record, this concern might seem overdone: Commentators generally agree that China's economy will continue to grow between 5 and 8 percent a year, far higher than all other major economies. China's leaders, however, view the decline as a source of great concern -- China's economic growth dropped to 7.6 percent year-on-year in the second quarter, its slowest rate in three years. Their claim to authority has been built on delivering double-digit growth rates that have transformed China into a global economic power; without such growth they see a threat to their "Mandate of Heaven."

Many analysts both inside China and out see this slowdown continuing and argue that China's development model should shift away from its heavy emphasis on investment and exports to one based more on domestic consumption. Over the past three years China splurged on a decade's worth of infrastructure projects; the country won't need any more roads, airports, trains and bridges for a long time. So as global demand for China's exports slows and such investment projects are finished, the best hope for continued growth is stimulating the Chinese consumer. The poor performance of the country's stock markets supports such an argument, suggesting why a new development direction is needed and also shedding light on some of the difficulties such a transition would face.

Since 1992, the MSCI China Index, the most broadly referenced indicator of Chinese market performance, is down over 40 percent, while the Shanghai Composite Index has risen only a meager 180 percent. During the same period, China's GDP has rocketed 1,700 percent. This suggests that China's listed companies have not been significant drivers of the country's fantastic growth, and that the capital they have received from investors -- some $950 billion from the Hong Kong and domestic markets over the last 20 years -- has been seriously misallocated.

The underperformance of China's listed companies is a direct consequence of Beijing's deliberately awkward adaptation of Western-style stock markets to a command-type economy. Despite the country's increasingly first-rate infrastructure and all the other trappings (bankers, investors, regulators, scandals) of development, China's markets only superficially resemble markets elsewhere. A market is where the ownership of a commodity or service is exchanged, not just where securities can be traded on a daily basis. Chinese stock markets do the latter extremely well, but have nothing to do with the exchange of ownership. At a fundamental level, China's markets do not price companies and their businesses because its listed companies are not for sale, and never have been. As Liu Hongru, the first head of the securities regulator and the godfather of China's markets, said in 1992, "The shareholding system is not privatization."

Beijing created its stock markets in the early 1990s because of concern with the poor performance of its state-owned enterprises (SOEs). During the 1980s, private enterprise growth far exceeded that of the SOEs. The government became convinced that adopting the Western capital markets model -- diversifying ownership, creating clear corporate structures, and establishing professional legal and audit industries and strong market regulators -- would improve SOE management and help them become more competitive both domestically and internationally.

What happened instead was that Beijing excluded non-state companies from the markets and required that absolute ownership control (at least 51 percent) of SOEs remain firmly in the state's hands. As a result, the stock markets have always been the near-exclusive preserve of the state and its own enterprises (the very recent opening in 2009 of the Shenzhen Exchange to private enterprises notwithstanding). This means that only a minority of a company's shares trade. The negative repercussions of this arrangement have reverberated far beyond the markets themselves.

Because the state dominates the markets (which it manages and regulates on behalf of companies it owns as the controlling investor), it can channel capital as it likes: An initial public offering (IPO) is fundamentally a bank loan from a state-controlled bank, not the result of a business owner selling a stake in his company to outside investors seeking the highest return on their capital, as we think of in the West. The Chinese government has used this control to create oligopolies and monopolies -- the so-called national champions -- run by high-ranking political appointees.

In real markets, companies' attempts to raise capital, as a result, can fail. Not in China! There the government literally sets the price of new shares based on how much funding it needs to raise, then directs other government-controlled entities to invest. Roughly 40 percent of the $9 billion raised in the Shanghai market for the July 2010 IPO of the Agricultural Bank of China, for instance came from other SOEs. This, combined with the more than $13 billion raised on the Hong Kong exchange, helped the bank's IPO to become on the face of it the largest in the history on any market globally. Another first for China

That's not how equity markets are supposed to work. Substituting the state for market forces eliminates the fundamental valuation function of the market, turning it into an arena for speculation where the value of a share reflects market liquidity and investor expectations driven by government policy and the latest rumor or suggestion of government intervention, subsidy, or stimulus. Faith in a business strategy, product innovation or the quality of corporate management is secondary to what investors think the government wants. As a result, China's investors, retail or institutional, lack the capacity to value companies: There is no need. Nor have China's investment banks (or, for that matter, the government) developed the core competency of analyzing a company and its industry as the basis for equity valuation. The likelihood that a Steve Jobs could raise significant amounts of capital in such markets would depend almost completely on his relationship with the government and not on his innovative vision. China's premier economist, Wu Jinglian, famously called China's stock markets "casinos" and a major source of "crony capitalism." If anything, he was too gentle.

Handicapped as they are by government intervention, China's markets nonetheless represent an important achievement and have played an important role in the country's transformation. Their existence as national markets mobilizing capital across the country, including Hong Kong, represents one of China's least-recognized triumphs of reform: Over its thousands of years of history, China has never had national markets of any kind.  Markets in China, especially financial ones, have always been fragmented because the country itself was always fragmented despite its seeming unity. This is one of the reasons why, in the 1980s and 1990s, Chinese companies were small, uncompetitive and unknown. Now, 44 Chinese companies appear on the Fortune Global 500 list, and the Industrial and Commercial Bank of China is currently the world's most valuable banking institution. These national champions could not have been created without the stock markets and international financial techniques.

China's exchanges have also given Beijing's reforms the veneer of a modern economy. The Shanghai Stock Exchange began with eight tiny companies in 1990 and now has more than 900; the top 10 companies command a market capitalization of $880 billion. And like markets everywhere they have seen incredible rallies and collapses. From 2005 to 2007 the Shanghai Index rallied from 1,000 points to over 6,000, and the daily traded value of shares surpassed that of all other Asian markets combined, before falling back to near 1,500 in 2008.

To truly reform these markets, the state must exit. China would have to open its markets to private domestic companies and foreign participants and allow the privatization of its SOEs, using a more sophisticated form of control while permitting a full float of company shares. This would create true market capacity for valuing companies, pricing capital and directing it towards those with the best economic returns. In turn, this would contribute to greater economic growth.

If the benefits are so obvious, why won't China reform its stock markets? The most basic reason is that there has never really been private property in China, except during the 1920s and 30s, when the country was colonized and governed by Western countries. Today's Chinese government, like those of the emperors before it, believes it owns everything. To allow genuine privatization would be tantamount to handing over vast swaths of the economy to foreigners, and the government -- officially still socialist -- would lose control domestically. For a group of men whose first instinct is to maintain control at any cost, this just can't be allowed to happen. Which is why we'd be very surprised if it did.

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