Saturday, November 22, 2014

The Changing Face of Global Risk

NEW YORK – The world’s economic, financial, and geopolitical risks are shifting. Some risks now have a lower probability – even if they are not fully extinguished. Others are becoming more likely and important.

A year or two ago, six main risks stood at center stage:

· A eurozone breakup (including a Greek exit and loss of access to capital markets for Italy and/or Spain).

· A fiscal crisis in the United States (owing to further political fights over the debt ceiling and another government shutdown).

· A public-debt crisis in Japan (as the combination of recession, deflation, and high deficits drove up the debt/GDP ratio).

· Deflation in many advanced economies.

· War between Israel and Iran over alleged Iranian nuclear proliferation.

· A wider breakdown of regional order in the Middle East.

These risks have now been reduced. Thanks to European Central Bank President Mario Draghi’s “whatever it takes” speech, new financial facilities to stabilize distressed sovereign debtors, and the beginning of a banking union, the eurozone is no longer on the verge of collapse. In the US, President Barack Obama and Congressional Republicans have for now agreed on a truce to avoid the threat of another government shutdown over the need to raise the debt ceiling.

In Japan, the first two “arrows” of Prime Minister Shinzo Abe’s economic strategy – monetary easing and fiscal expansion – have boosted growth and stopped deflation. Now the third arrow of “Abenomics” – structural reforms – together with the start of long-term fiscal consolidation, could lead to debt stabilization (though the economic impact of the coming consumption-tax hike is uncertain).

Similarly, the risk of deflation worldwide has been contained via exotic and unconventional monetary policies: near-zero interest rates, quantitative easing, credit easing, and forward guidance. And the risk of a war between Israel and Iran has been reduced by the interim agreement on Iran’s nuclear program concluded last November. The falling fear premium has led to a drop in oil prices, even if many doubt Iran’s sincerity and worry that it is merely trying to buy time while still enriching uranium.

Though many Middle East countries remain highly unstable, none of them is systemically important in financial terms, and no conflict so far has seriously shocked global oil and gas supplies. But, of course, exacerbation of some of these crises and conflicts could lead to renewed concerns about energy security. More important, as the risks of recent years have receded, six other risks have been growing.

For starters, there is the risk of a hard landing in China. The rebalancing of growth away from fixed investment and toward private consumption is occurring too slowly, because every time annual GDP growth slows toward 7%, the authorities panic and double down on another round of credit-fueled capital investment. This then leads to more bad assets and non-performing loans, more excessive investment in real estate, infrastructure, and industrial capacity, and more public and private debt. By next year, there may be no road left down which to kick the can.

There is also the risk of policy mistakes by the US Federal Reserve as it exits monetary easing. Last year, the Fed’s mere announcement that it would gradually wind down its monthly purchases of long-term financial assets triggered a “taper” tantrum in global financial markets and emerging markets. This year, tapering is priced in, but uncertainty about the timing and speed of the Fed’s efforts to normalize policy interest rates is creating volatility. Some investors and governments now worry that the Fed may raise rates too soon and too fast, causing economic and financial shockwaves.

Third, the Fed may actually exit zero rates too late and too slowly (its current plan would normalize rates to 4% only by 2018), thus causing another asset-price boom – and an eventual bust. Indeed, unconventional monetary policies in the US and other advanced economies have already led to massive asset-price reflation, which in due course could cause bubbles in real estate, credit, and equity markets.

Fourth, the crises in some fragile emerging markets may worsen. Emerging markets are facing headwinds (owing to a fall in commodity prices and the risks associated with China’s structural transformation and the Fed’s monetary-policy shift) at a time when their own macroeconomic policies are still too loose and the lack of structural reforms has undermined potential growth. Moreover many of these emerging markets face political and electoral risks.

Fifth, there is a serious risk that the current conflict in Ukraine will lead to Cold War II – and possibly even a hot war if Russia invades the east of the country. The economic consequences of such an outcome – owing to its impact on energy supplies and investment flows, in addition to the destruction of lives and physical capital – would be immense.

Finally, there is a similar risk that Asia’s terrestrial and maritime territorial disagreements (starting with the disputes between China and Japan) could escalate into outright military conflict. Such geopolitical risks – were they to materialize – would have a systemic economic and financial impact.

So far, financial markets have been sanguine about these new rising risks. Volatility has increased only modestly, while asset prices have held up. Noise about these risks has occasionally (but only briefly) shaken investors’ confidence, and modest market corrections have tended to reverse themselves.

Investors may be right that these risks will not materialize in their more severe form, or that loose monetary policies in advanced economies and continued recovery will contain such risks. But investors may be deluding themselves that the probability of these risks is low – and thus may be unpleasantly surprised when one or more of them materializes.

Indeed, as was the case with the global financial crisis, investors seem unable to estimate, price, and hedge such tail risks properly. Only time will tell whether their current nonchalance constitutes another failure to assess and prepare for extreme events.

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    1. CommentedDavid Donovan

      I bring this up to Nouriel because it is reflective as to why America's willingness to retreat will have adverse effects and in fact devastating effects on global security

    2. CommentedRishi Arora

      Although I agree with dr Roubini that the risks are mitigated, I have to disagree to what extent. Although we are not in a crisis, it doesn't mean the rose garden is flowering again! The structural reforms required whilst QE was in full flow were not carried out to a greater enough extend and I suspect we will see that as QE is wound up in the US. It may take longer if the EU take up the baton and continue where the US leaves off- which seems ever more likely.

      I am surprised after 5 years that the market hasn't worked out that this "medicine" (QE) is not working on the fundamental economy.

      I would argue a even more worrying sign- if you look at the trends, we are in a disinflationary world and with a lot of regions in Europe already in deflation... I personally can't see that stopping particularly if we see a significant external shock. My logic is this, we have had 4 trillion dollars printed in the US... They have disinflation- I would argue and I know this sounds contentious, QE isn't creating inflation.

      If this is the case, all QE effectively does is pump up asset prices... A problem pre 2008 was interest rates were too low for too long and I fear we are performing exactly the wrong medicine, creating a supercharged bubble that will eventually pop.

      The solution would have been supply side reforms, reforms to the tax systems to make them more progressive. Higher punishments on banks and strong regulation so they work for the people. International corporation including international rules on banking, trade and a world wide development strategy. I know a lot of what I recommend just isn't possible in a politically fractured world...

    3. CommentedMichael Cohen

      The two big recessions 1929 and 2008 were not caused by the kind of natural risks referenced here, they were instead caused by massive fraud in the financial sector.

      Specifically for the 2008 meltdown.
      - Banks gave over vetting home borrowers to independent retail mortgage brokers that lured people into unsustainable mortgages with teaser rates and high pre-payment penalties. The mortgage brokers didn't care, they unloaded the bonds onto banks
      - The banks with the collusion of the ratings agencies. Bundled the toxic waste into AAA rated securities.
      - Using political influence over Congress, the market for credit default swaps went completely unregulated. For every $1 in bad mortgage bonds, there was $10 in credit default swaps that the issuers were not required to maintain adequate funds to cover.
      - While all this was going on the SEC and Fed under Greenspan were asleep at the switch. As an example, given specific information about Bernie Maddof's Ponzi Scheme, the SEC sent in investigators that gave him a clean bill of health.
      - When the toxic waste bonds went bad as they were bound to do, there were so many suspect credit default swaps issued that nobody knew who would actually get paid off, banks and brokers financial statement became suspect, the overnight loan rate skyrocketed and the banking system threatened to seize up.

      THERE ARE NO MYSTERIES HERE; just public and private corruption and incompetence on a grand scale which has left a very well of class of rich and powerful un-indicted co-conspirators, still out there waiting for another opportunity to get rich on the backs of the people who make a living by producing goods and services of real value.

    4. CommentedJason Gower

      "Could" lead to bubbles in equity markets? Probably the only question here is who will be left holding the bag. It's like everybody has their finger on the sell button just waiting for the signal but of course the returns look good on the way up so don't want to get out of there too soon...

    5. CommentedZsolt Hermann

      I am not sure I would deem the listed problems even partially resolved at the beginning of the article.
      The "solutions" cited as lessening their threat, are simply sweeping the problems under the carpet, inflating the already stretched bubbles even more, none of the "solutions" addressed the true, core causes of the crises.
      Even the Middle East looks more dangerous than before to me. As the dominance, meaningful influence of the US lessens, and as the "rogue" actions of Russia and other states remain relatively unpunished, more and more countries, leaders will feel they can act in isolation, dictated by their personal or national interest even against the backdrop of international condemnation, or "sanctions". And in the complicated, overheated atmosphere of the Middle East such actions could lead to highly unpredictable consequences.
      Unfortunately I only see a generally worsening picture, a dark vacuum opening up as the crisis deepens on all fronts, the "solutions" are very clearly simply "kicking the can down the road" and there are no visionaries, leaders who at least promise something for a better, more sustainable future.
      Everybody is standing naked and empty handed.
      On top of this all we just received an even more alarmist environmental perspective than we had before.
      We are at very sensitive and volatile crossroads.
      We cannot delay further looking into the mirror and identifying the true causes of the crisis and all of humanity's problem.
      There cannot be a cure before a brutally honest diagnoses.
      Of course instinctively we try to avoid it since the diagnosis is not concerning some external factors, or "others", but the "disease", the "bug" is in us, in our self-centered and egoistic human nature.
      This is the nature that drives us towards ruthless competition, thriving to succeed at the expense of others, this is what drives us to live based on excessive and artificial demand way beyond available resources and necessities.
      And continuing life such a way in a closed and finite natural system, where we have become a global and integral human organism is like consciously driving off the cliff into the abyss.
      We cannot afford to continue existing on our instincts, without conscious and critical self-assessment and conscious and positive self-change.
      These conscious acts would make us truly human, a creature rising above its own inherent nature in order to adapt to the system around it, and only such a truly human being can adapt to and survive evolution.

    6. CommentedVal Samonis

      Deflation, esp. in Europe and Japan, is still a growing risk; nothing has been able to stop it so far (not Draghi, not Abe). What will stop deflationary tendencies are wars, precisely, with all kinds of fiscal and monetary stimulation they will require, as usual.

      A kind of deja vu from the Dirty Thirties and Bloody Forties?

      Val Samonis

      Vilnius U and Royal Roads U