Political and Economic Risks for the Year Ahead

What to look out for in a turbulent 2009

Originally published in the February 2009 issue

With Ian Bremmer, President of Eurasia Group, and Nouriel Roubini, Professor of Economics and International Business, Stern School of Business, New York University

The following is based on a transcript of a briefing with Ian Bremmer and Nouriel Roubini for the global media on 13 January 2009.

Ian Bremmer: So, without further ado, let me start by looking at the market environment. A couple of points. I’m a political scientist, for those of you that don’t know me. And geopolitical risk in 2009 is actually a little greater than it was in 2008. Iraq is getting a little bit better and I think that’s significant. But if you leave Iraq aside, almost all of the significant underlying geopolitical risks are larger in ‘09 than they were in ‘08.

I will talk about these in greater detail later, but certainly the entirety of the security environment in South Asia is getting significantly worse and will have spillover implications. The Iran issue, specifically as it ties in with not just nuclear relations and development, but also vis-à-vis Israel and the potential for proxy fighting more broadly into Lebanon and into the Palestinian territories, is much more significant than it was. Geopolitical tensions around Russia are growing. The geopolitical environment for the production of oil is becoming more significant on many fronts.

All of these are risks that we’re going to devote more attention to in 2009 than 2008. But the markets will pay less attention to them because, if we look at what is going to be driving the headlines, it will be overwhelmingly the global financial crisis.

As a consequence of that, as geopolitical risks hit, they will be surprised in the markets. They won’t be priced in the way they were, for example, at the beginning of the Iraq war when everyone knew that the troops were there in Kuwait. Everyone knew they were going in. It was only a question of what day it was and, frankly, once the war started there was a relief rally because the uncertainty was finally gone from the market. This is an environment where additional geopolitical risks will have more significant impact on market conditions because they won’t be priced in and people won’t be focusing on them.

The second point I’d want to make from a market environment perspective is that this is, from my perspective, the most significant year for political risk at large than we’ve seen since WWII. That has to do a little bit structurally because of the increasing importance of state capitalism as opposed to multinational corporations and globalization driving economic outcomes. Increasingly, the principal economic actors in the world are governmental actors. That’s been true for a long time. It’s been true more recently with state-owned enterprises in emerging markets like China and Russia. It’s been true even more recently with the extraordinary rise of sovereign wealth funds in terms of asset management and investment.

But most recently, in the course of the last six months, it’s been true because of the extraordinary importance of stimulus packages and of government bailouts in responding to the global financial crisis. New York City used to be the world’s financial capital. It is no longer the economic capital of the United States; Washington is. The same can be said with the extraordinary transition of power and of policy, important for markets from Shanghai to Beijing, from Dubai to Abu Dhabi, even from Mumbai to New Delhi; a much more decentralized environment, but still important.

That’s clearly going to have an impact on the importance of lobbying and on the growth of government relations offices for corporates all over the world. But it’s also going to have an impact in terms of where we see the potential for inefficiencies, of the possibility for market outcomes to be more regionalized as opposed to globalized. The same is true of capital flows. All of that is stemming directly from a political risk environment that is really unprecedented in the post-industrial age.

Nouriel Roubini: I would like to speak a little bit about the economic and the financial risk, given that Ian spoke about the geopolitical one. My first observation is that it’s clear by now that last year we had the worst financial crisis in the global economy since the Great Depression. And my concern is that, while there is a bit of optimism right now in the market, with the rallying equities starting late November, 20% plus, I think that that’s based on diluted expectation about economic recovery.

The consensus is the US and the global economy returning to growth in the second half of 2009. The work that myself and my colleagues at RGE Monitor have done, we’ve just published a 75-page global economic outlook for each country and region, suggests otherwise. There’s going to be a very severe and synchronized global economic recession.

Before I get to the themes of that recession, a few observations about the financial system. Last year I estimated that credit losses could be at least $1 trillion, maybe as high as $2 trillion. We’re revising this estimate based on actual amounts of the defaults on a variety of asset classes. It’s not any more just subprime, it’s subprime and prime mortgages, commercial real estate, credit cards, auto loans, student loans, leveraged loans, NBOs, investment commercial loans, corporate bonds. We have started getting numbers now, numbers close to $3 trillion of credit losses.

That means that, effectively, most of the US financial system is insolvent. Therefore, these credit crunches will continue. Unless we resolve the problems in the financial systems, there’s not going to be a restoration of credit and, therefore, the economic growth of spending, consumption, investment and so on.

And now, we’re seeing globally a massive downturn in cap-ex spending. It’s not just in the United States. There was an excess supply of goods and services, because of overinvestment by China, Asia, emerging markets. Aggregate demand is falling sharply. Capex spending is sharply falling across the board, in addition to consumption and residential. This falling capex spending in our view is going to be a big story. It’s going to lead to an exacerbation of this economic contraction. This, for the first time in decades, is synchronized with a global recession.

That’s important because our knowledge suggests this recession is going to be the worst the US has had in the last 50 years, three times as long as the previous two, and three times as deep. And it is not going to bottom-out before the end of this year. And even next year, if there’s going to be a recovery of growth, it’s going to be rather shallow.

But the most important thing is that while, by the middle of 2008, only the US was in a contraction, or was in the third and the fourth quarter of last year, we see a recession in the Eurozone, in the UK, in the rest of Europe, Australia and New Zealand, Canada, Japan, essentially a synchronized recession, 60% of global GDP being in negative growth.

And now, trade channels, financial channels, credit channels, commodity channels are leading to a massive slowdown of growth in emerging market economies. Wesee significant growth slowdown in the BRICs, in Asia and Latin America, in other emerging markets.

That leads me to two other observations. The first one is that the biggest problem that we’re going to face right now is not going to be the risk of inflation. Some people were worried last year with rising oil, energy and commodity prices. There’s going to be the risk of what I call slack deflation, the combination of economic stagnation, recession, and deflationary forces.

Why deflationary forces? Because you have slack in goods markets with demand following relative supply, slack in labor markets with rising unemployment rates, and slack in commodity markets with commodity prices falling sharply from their peaks of December. In this context of a global recession, in our view, commodity prices could fall another 15 to 20% from the current levels. So, deflation and the pressure they’re going to put on policy, monetary policy, is going to be a significant risk.

That leads me to the final observation. For risky assets, equities and others, there is a perception that maybe the worst is behind us. There’s going to be a recovery of risky assets in the US and global equities. We’re pessimistic for three reasons. Macro news for the next few months is going to be much worse than expected, earnings news is going to be much worse than expected, and financial shocks coming from the financial system, from emerging markets, from hedge funds, are going to be worse than expected. Therefore, we see down service to global equity of another 20% in the next few months.

Ian Bremmer: Now we’re going to talk about the United States, and specifically the transition to the Obama administration and the new Congress.

Nouriel Roubini: I would like to point out on the United States, first of all, there will be a very severe recession. I think there is a bit of optimism as a result of very aggressive monetary policies. Five hundred down to zero, quantitative of easing, a variety of 15-plus programs to reduce the spread between market rate and policy rate is going to lead to a recovery. And then there’s the fiscal stimulus; the market is expecting a budget of $1.2 trillion this year and $1 trillion next year, even before this $800 billion fiscal stimulus. The combination of that monetary and fiscal ease is going to lead to economic recovery in the second half of the year.

I think there are several reasons why we are skeptical that this policy stimulus is going to make a big difference in 2009, and maybe the effects of it are going to be seen in 2010. But even in 2010, we see economic growth well below potential.

For monetary policy, the important point here is that this is not just a liquidity crisis. There is a credit and solvency crisis. And monetary policy cannot resolve fundamental credit and solvency problems in the economy; you have insolvencies among households, in financial institutions, and even in a part of the corporate sector. Just easy money by loan is not going to work. There is a massive credit crunch still in the corporate sector.

Fiscal policy stimulus is necessary because there certainly will be a severe recession, even more severe because aggregate demand in the private sector is collapsing; consumption, residential investment, corporate spending, capex spending; we need this boost. But let’s be realistic. It’s not going to be a free lunch. We’re going to run up debt of a $1 trillion this year, another $1 trillion next year. Right now, long rates for government bonds are low, but with this tsunami of government debt being issued by the market, and purchasing countries like China, Russia, the Gulf States and others facing budget deficits, their ability and willingness to buy all this new debt is going to be limited. What might happen is that actual interest rates might go up, the dollar might weaken further, and the increasing interest rates might crowd out private spending. For factories who have to issue a huge amount of debt, that’s going to lead potentially to other side effects.

Fiscal policy is not a free lunch. Eventually we’ll have to raise taxes and cut government spending to finance this huge increase of $2 trillion in public debt, unless we were to go through the route of inflation or default, something the US is not likely to do.

Resolving the credit problems for the financial system is going to take time. You cannot just throw money at it. You have to be selective. We need another $500 billion to $600 billion to bring back the capital ratio of the banks to a point at which they feel comfortable about lending again. Right now, they’re holding liquidity, they’re holding the capital that the government’s injecting. They’re not lending and you cannot force them to lend. So, your result is fundamental insolvency of the financial system.

There is also an insolvency in the United States of the housing sector. A good chunk of the sector is buried under a mountain of mortgage debt, credit card, auto loans, student loans, and consumers cannot essentially spend until you reduce the face value of this debt. When a country is insolvent, Argentina, Ecuador, Russia, they default, reduce the face value of the debt, and then they start growing again. When a firm is insolvent, you’re in Chapter 11, you reduce the face value of the debt and you start spending and investing again. Same thing for the housing sector. You need a face value reduction of the debt. But that’s very complicated. How are you going to do it? If you do it case by case it’s going to take years. And this mortgage crisis, this foreclosure crisis, is going to continue putting downward pressure on home prices. If you want to do it across the board, face value reduction, you have to break every contract. You just cram down a debt reduction across the board. For the insolvent housing sector, it requires careful policing of those economic difficulties

The basic point is monetary fiscal stimulus is not enough. You have to deal with the credit crisis, the insolvency of the financial system, and the insolvency of the housing sector. That’s going to take time. That’s why the recovery is going to be slower than otherwise.

Ian Bremmer: From a political perspective, let me first add to a point that Nouriel made, which I think is very important, the notion that the ability of the United States to increasingly have the same level of access to financing internationally is going to be very, very challenging indeed. When Nouriel and I went to Davos last January, everyone was talking about decoupling, the notion of how much the world was becoming economically decoupled. And now, of course, with the financial crisis, there is a notion that that was all clearly a myth, because the United States has sneezed and the world has caught a rather significant cold.

As a political scientist, I would say that we have seen a very significant decoupling in the world that is speeding up. It is a political decoupling. That there is a very clear sense that it is increasingly governments that are determining where economic capital is going to go and how the international marketplace is going to work, that we are seeing a desire to prioritise the national interest, to prioritise local state sectors, and not to respond to what the United States wishes, whether it’s on a geopolitical issue or whether it’s on an offering in the United States on the equities side.

That used to be true a couple of years ago, but it wasn’t as important. We didn’t pay as much attention because if your own domestic environment is your own priority and you’re Abu Dhabi and you’re China, and you can fund your top five priorities, it doesn’t really matter what your first or second or third priority is. Everyone is getting cash. That’s not true today. And if you are a sovereign wealth fund in China or in Abu Dhabi or in Russia, your first priority is to ensure that you are bailing yourself out and that there is local political stability. Your second is increasingly regional. And then, you start to think about a place like the United States. I think that environment is going to be very different indeed. The United States is going to be operating in environments in which it will be increasingly difficult to attract support for the policies that the US is putting forward.
In our report for the top risks of the year ahead we’ve always said that emerging markets were the places where political risk was the most important in terms of market implications and outcomes. In 2009, that’s actually not true. In 2009, the biggest political risk is actually in the United States. It’s the impact of Congress.

There’s no question that the Obama administration has a very cohesive economic team, much more ideologically centrist than what many have been concerned about as the Obama administration was coming together. But there’s also a much more cohesive Congress. It’s much more progressive. And it also has a strong sense that the executive branch of government over the last few years has seriously overstepped its policy making authority, both on economic and on foreign policy fronts. This is going to be a Congress that’s going to feel the need to respond decisively to this financial crisis, to show that it’s actually taking serious action, to show their own domestic constituents that they are deserving of their office. That’s going to lead congress to move from a position of stalling legislation that comes out of the executive, to try and exert actual policy leadership.

There are a few areas that I would watch on that front that are going to have economic implications. First, on the financial industry side – legislative and regulatory changes: oversight and supervision for credit rating agencies, revision of bankruptcy laws, new regulation of complex financial products. Most importantly, reform of the financial regulatory agencies.

A second big set is direct government involvement and control over economic enterprises. We’ve already seen that in financial institutions, but now automotive, and other sectors as domestic constituencies of different congressmen demand that they see their piece of the stimulus package. As well as the criminalization of company failures, different hearings and investigations and special prosecutors for underperforming enterprises are on the cards.

And the third and final issue will be the fiscal policies that are actually meant to spur economic growth. The implementation of the second half of the package is where we’re already seeing some congressional pushback and some sparring between Democrats and Republicans over how quickly and how decisively they’re going to respond to Obama’s request for letting that free.

Also, there is the new infrastructure stimulus that’s going to be coming down the pike. Obama came out just recently saying there’ll be no earmarks. But what does it mean to say no earmarks? One congressman’s bridge is another congressman’s bridge to nowhere. This is going to be a very politicized process. And it’s one that the international marketplace, I think, while very, very excited about Obama coming in, and hoping that things are going to get better from a policy perspective, is going to find that the potential for slowing policy, for making policy more inefficient coming out of Congress, is going to be very serious indeed.

I talked a little bit about South Asia. It is clear that the security environment in Pakistan, Afghanistan and in India will get worse in 2009 than it was in 2008. The United States and Europe will have more engagement, politically, economically and directly militarily in Pakistan and Afghanistan in ‘09 than they did in ‘08. And they will have less to show for it. They will increasingly make headlines. And some of that will spill over because, increasingly, the global locus for the war on terror has been moving eastward over the last decade from Israel, Palestine, through Iran, Iraq, now to South Asia. We’re going to be paying more attention there.

The second big risk out there is Iran/Israel. The Iran risk had primarily been one of the United States potentially engaging with the Iranians militarily to try to prevent them from developing nuclear weapons capacity. In 2009 that shifts to Israel and Iran both having elections.

Israel is recognising the Americans are not going to take action to stop the Iranians. This is very clear from this weekend’s articles in the New York Times. But the Iranians recognise that, too. That could lead to provocations on the part of both governments as they run through their domestic elections. There is a reasonable chance that the Israelis might engage in military strikes against Iran. But if they don’t, which is more likely than not, then the Israelis could recognise that this is their time horizon to go after Iranian proxies in the region, like Hamas and, more importantly for regional stability, Hezbollah. So really, the Israeli and the Iranian risks could come together in 2009 in a way that they have not previously.

The other big political risk out there is around Russia. We’ve been seeing every morning as we come into the office the Russia/Ukraine on again/off again conflict in terms of the lack of gas flow, both to Ukraine and also throughput into Europe. The Russian government clearly is leveraging their political influence over Ukraine and over a very fragmented Ukrainian government to say that they wish Eurasia, broadly speaking, to be an area of unique Russian involvement. And if that means that the Russians are going to experience economic downside, even with $35 oil, so be it.

There were a lot of people that were asking, would the Russians have done what they did in Teplice at the beginning of the Olympics, going into Georgia with tanks if oil prices had been at $30; they only did that because they were confident with oil prices at $120? Actually, no. The fact is that, for Moscow, politics increasingly trumps economics, especially if their security complex is concerned. And that creates geopolitical risk more broadly in the region.

Now, I want to be optimistic about a few things here as well. I think there are some places where political risk frankly is overplayed and where we are less worried. Stability, broadly speaking, in the Persian Gulf, even despite low oil prices and despite the Iranian conflict, we think is quite low. In general, we think the Persian Gulf will over-perform vis-à-vis market expectations, particularly Saudi Arabia, but also the Emirates, even Dubai when the bubble of their economy is bailed out by Abu Dhabi. They’re going to experience, no question, some difficulties in terms of the amount of power they will have to bring to bear and influence over the UAE as a whole. But the markets we think will be stable there. Qatar, even Kuwait we think, will do well in this environment.

Brazil we’re quite positive about from a political stability perspective. Over 80% approval for Lula [da Silva]. It allows him to put through a lot of reforms that a lot of other countries can’t get done. In Indonesia that’s also true. In fact, [Susilo Bambang] Yudhoyono who looked like he potentially was going to lose against Megawati [Sukarnoputri] just six months ago, now looks like he has clear sailing. And his party is probably set up to become the leader in seats in the parliament when their elections go through later this year. That’s going to give Yudhoyono the ability to push through difficult political and economic reforms that, frankly, still aren’t being priced in by the markets. We think there’s upside.

The final place that I see upside is actually in China. I think the folks that think that China’s going to fall apart when they have a hard landing economically are overstating their case. That may have been true 10 years ago or 20 years ago. China’s built up an enormous amount of political capital domestically. To the extent the Chinese population is annoyed about the fact that Chinais facing this downturn, and they certainly are, they’re focusing much more on the fact that that’s come from the west, come from the United States, and it’s come from demand and desires to engage in a free market system the Chinese have never completely believed in.

I think you’ll see more economic nationalism coming out of China, but I don’t think you’ll see political instability in a meaningful way in 2009.
Nouriel Roubini: I would like also to try to emphasize some of the international aspects by talking about the emerging market economy. As I said, falling commodity prices have led to a massive slowdown of growth in emerging markets. But I think that the main concern I have is that some of these emerging market economies are actually on the verge of a broader financial crisis. This financial crisis is a combination of a currency, banking, sudden debt or systemic corporate crisis. I’m not saying that each one of these countries that I’m going to list are going to have a serious financial crisis because the enterprise community, IMF, ECB, US and others are going to help, and some of them are going to be able to avoid a more severe economic and financial downturn but there are risks there.

First of all, I see risk in emerging Europe, countries that have large current account deficit and other imbalances; the Baltics, Latvia, Estonia, Lithuania. If you go further south, countries like Hungary, Romania, Bulgaria and Turkey, and further east, Ukraine, Belarus, Russia.

If you go into Asia, there are significant financial pressures of course in Pakistan, but also in Indonesia. Even a country like Korea has significant trouble in many dimensions. If you go to Latin America you have Argentina, Venezuela, Ecuador. Ecuador just defaulted for the third time on their sovereign debt. There are significant fiscal imbalances and other imbalances in South Africa. There’s a list of about 12 to 15 emerging market economies that are subject to significant financial pressure.

And I see that there is a subset of those countries that are also matching those where Ian is seeing some geopolitical risk. Certainly in the list of geopolitical risk were countries like Turkey, Ukraine and Pakistan, but also Mexico, South Africa and Russia. So, the combination of a risk of economic and financial crisis with a geopolitical risk within those countries may be a nexus that can be particularly dangerous and a thing to keep in mind.

You know, for the last few years people have talked about the success and the rise of the BRICs. And I think that one can be bullish about the BRICs over the medium/long term because, as long as they continue their macro structural reforms, their growth can be sustained. Given the size of their proliferation, their GDPs are going to become large. They’re going to become a bigger player, not just in economic and financial markets, but also geopolitical ones. But I see some risk there.

First of all, with oil prices this low, I think that this year Russia’s going to have a very, very severe recession; minus-2, minus-3 percent growth. Whether that is going to make Russia more aggressive or more malleable, I don’t know. That’s a geopolitical question that maybe Ian can answer, but that’s a major risk. Severe recession. They were growing 8%, now negative 3.

Take China. For a country like China that needs to move about 10 million poor rural farmers to the modern, urban industrial sector every year, to do that you need about a growth rate of 10%. Today, this year, we’re going to have in China a hard landing, a growth rate of 5% or even lower than 5%. And for China, 5% growth is a hard landing. It may not lead to a revolution in China. It might lead to anger. It might be towards the United States, it might be to nationalists, but the lower the growth becomes the greater are going to be those kinds of social pressures within China. That’s a concern. So, in the medium run China can do very well, but this is going to be a very, verydifficult year.

Take the rest of the BRICs. In India we see economic growth falling to 5% this year. India is a country that has not opened up as much to trade, to FDI like China did. You have a major fiscal problem here. You have rigidity of the size of the government, labor market restrictions. And now you have internal/external geopolitical risk. There has also been these corporate standoffs. Can you even trust the balance sheets of corporations, their earnings and revenue statements? That can be a risk for India.

And for Brazil, of course, the market and financial fundamentals are good. But in a world with lower growth, lower export, lower commodity prices, and a credit crunch, they’ll be lucky this year to have a growth rate of 1%. And a country so poor like Brazil needs to go to 3, 4 percentage points to deal with issues of poverty and inequality and so on. So, even the BRICs are going to have a very, very hard year.

A final observation I will make is, in our scenario of a severe global recession, oil prices could be in the $30 to $40 range. What does that imply for the stability, internal and external and aggressiveness of a bunch of unstable petro states? I don’t know. But think about Nigeria. Think about Venezuela, Iran, Iraq, also Russia. Are they going to become calmer, more conducive to engagement with the West and US or are they going to become more aggressive?

Ian Bremmer is co-author of “The Fat Tail: The Power of Political Knowledge for Strategic Investing” and president of Eurasia Group.

Nouriel Roubini is Professor at the Stern School, New York University and Chairman of RGE Monitor