2015 CCMR Executive Course in Decision Making Naval Postgraduate School October 27, 2015 Dr. Robert E. Looney Global Tensions and Economic Security Outline The Global Economic Crisis and Aftermath Overview Patterns of Recovery The Current Situation Forecasts/Scenarios Key Risks 1.Emerging Market Crisis 2.Instability from Oil Price Decline 3.African Debt Problems 4.Declining Defense Expenditures in the West General Lessons 2 The Global Crisis 3 Economic Crisis and Security Threats The global recession is Americas primary near-term security concern. Admiral Blair Director of National Intelligence (February 2009) The single biggest threat to national security is the national debt. Admiral Mullen, Chairman of the Joint Chiefs of Staff (August 2010) I have to confess, I paid no attention to this (economics) as a cadet and have done nothing to increase my awareness of economics issues between age 22 and 59. I should have paid attention. General Dempsey, Chairman of the Joint Chiefs of Staff (October 2011) 4 Global Economy Overview I The Changing Global System Before the crisis, the main feature of the global economy was its rapid integration has continued but at a slower pace since the crisis However, economic policies largely set at the national level to benefit domestic economy These policies are increasingly affecting other economies External effects are particularly important in the financial sector due to potential for large and abrupt changes in: Capital flows Asset prices Interest rates, exchange rates, and Credit availability. 5 Global Economy Overview II The global economic crisis and its aftermath illustrate this new reality Characterized by defective growth models in advanced economies based on Excess monetary expansion/credit and Debt-driven domestic aggregate demand Complicated by structural flaws and limited adjustment mechanisms especially in Europe leading to Instability An on-going crisis Large negative shock to the real economy Emerging economies were subsequently affected by Credit tightening (including trade finance) Rapid declines in exports 6 Global Economy Overview III Post-crisis policy largely based on credit expansion and debt reduction Unconventional monetary policy United States Lowered cost of credit for debtors and those seeking to borrow for business expansion Came at the at expense of savers lower interest rates Did not work well because investment constrained by deficient domestic demand relative to capacity Savers sought higher returns in emerging economies Causing increases in credit and causing upward pressure on exchange rates and asset prices responded with Limits on capital inflows Reserve accumulation and Measures to restrict credit and restrain asset-price inflation 7 Global Economy Overview IV Situation changed in May 2013 when U.S. Federal reserve indicated it might taper its purchase of long-term assets Asset prices shifted and in emerging economies Capital rushed out, Caused credit markets to tighten and Exchange rates to fall Causing a slowdown in short-term growth. The reversals may have longer term adverse effects although not clear at this point While Chinas output is affected by advanced country economic performance financial system largely isolated Capital account less open, foreign currency reserves of $2.5 trillion mean exchange rate is controllable 8 Global Economy Overview V Decentralized policy and growing externalities will result in a partial de-globalization Not a good idea to run persistent current account deficits and become dependent on (temporarily) low-cost foreign capital Open capital accounts may be replaced by rules-based constraints on financial capital flows Lesson from crisis Pattern of accumulating reserves via current account surplus will be more pronounced in order to manage exchange rates Public purchases of domestic assets to stabilize asset prices net capital flows will become increasingly common. Successful countries will be those who learn to live with growing policy interdependency without much policy coordination 9 Crisis Has Accelerated Changes in World GDP 10 Decline of the G-8 11 Patterns of Future Pubic Debt 12 Debt Vulnerability 13 Crisis Has Resulted in Accelerated Divergence 14 Patterns of Recovery I 15 Patterns of Recovery II 16 Current Global Patterns I Today world economy is characterized by divergence While growth was centered in the advanced world in the 1970s, 1980s, and 1990s, more recently it has moved to emerging economies According to the International Monetary Fund of the eight countries expected to contribute most to global economic expansion over the next five years only U.S. and Korea are advanced economies The U.S. comes third contributing 10% of total world growth after China and India who contribute 45% Turkey is expected to add more growth in dollar terms to global economy over next five years than Germany 17 Current Global Patterns II 18 Current Global Patterns III Although emerging countries are more dynamic and are where global growth is located, they have disappointed forecasters time after time Every year since 2011 forecasters have started to predict the following years likely expansion only to grow more pessimistic as time passes Not only have forecasts for emerging economy growth persistently deteriorated for every year from 2012 to the latest forecasts for 2016 economists have learnt from the past. Every year they have been less optimistic than the last, but still surprised by even weaker data 19 Current Global Patterns IV 20 Current Global Patterns V Economists appear to have made four errors in forecasting: First they have extrapolated the rapid pre-crisis economic growth rates of emerging economies into the present Not noticing that underlying productivity growth has declined Second they have not taken sufficient notice of a slowing trend of employment growth in emerging markets Making growth harder to achieve Third as with slower growth many policy weaknesses have surfaced in many countries Corruption scandals in Brazil for example had been hidden by rapid growth Fourth with the surprise slower growth has come a sudden drop incommodity prices Particularly for those countries dependent on ore, metal and oil exports. 21 Current Global Patterns VI Comparing recent expctations for 2015 growth with those three years ago highlights the significant countries with the most disappointing economic performance countries which let themselves down Russia Most glaring example of unexpected weakness comes from Russia which was thought to be set for persistent growth rates of about 4% This year the economy will contract by about an equivalent value Hard hit by falling oil prices and economic sanactions following its military activity in the Ukraine 22 Current Global Patterns VII Brazil Country has gone from being one of the most dynamic economies in Latin America to one regarded as having Weak fundamentals Corporate scandals and A Fragile policy framework Nigeria and South Africa Been among the five most disappointing large economies compared with expectations three years ago Problem has been the fall in commodity prices China Commodity prices have not played a role Growth around 7% in well below 8.5% expected in Current Global Patterns VIII Countries which exceeded expectations Although global growth is slower than hoped three years ago many of the advanced economies are recovering faster than expected at the height of the euro crisis Spain A star performer expected to expand by more than 3% in 2015 compared with the 1.5% forecast in 2012 Germany Also exceeding expectations although its growth is still anticipated as being modest in 2015 and below 2% India Performing much better than anticipated -- Helped by lower commodity prices and better macroeconomic policy framework Growing at around 7.5% in 2015 abut a percent higher than anticipated 24 Current Global Patterns IX 25 Current Global Patterns X Generally there are relatively few star performers Explains the gloomy economic outlook However the overall-situation remains too strong to be talking yet of a global economic downturn. 26 Todays Problem Policy makers are in a bind in many countries In the Eurozone and Japan they are still trying to find ways to stimulate demand In the U.S. and U.K interest rates are about to increase, but there is widespread concern that any movement back to normal might trigger financial turmoil However leaving monetary policy loose will encourage excessive borrowing which may create bubbles and another financial crash In emerging markets the need is to push forward on structural reforms to labor and product markets as well as education and social security to enable more secure and rapid growth Not easy and mistakes are certain to happen. The economic environment in many parts of the world is thus quite fragile with forecasts increasingly pessimistic. 27 The New Normal I The current situation has been called The New Normal -It is characterized by: Deficient Demand hard to generate enough demand to absorb potential global supply threat of deflation Stagnant Productivity. In advanced countries productivity fallen from 2% a year to less than 1% Fragile Finance system may be even more fragile than before the crisis. Assets to equity very high making banks vulnerable Unstable Politics political stresses hostility towards elites, foreigners, international institutions make finding solutions difficult Tense Geopolitics Russia, China, ISIS, Iran, Ukraine create great uncertainty Challenge Overload both domestic and international. Breakdown of global governance when problems mounting maintain open global economy, climate change, peace. 28 The New Normal: II 29 IMF Forecast 10/ IMF Regional Forecasts 10/2015 I 31 IMF Regional Forecasts 10/2015 II 32 Possible Risks: Remaining 2015 I Looking ahead in 2015 Possible Risks United States U.S. Treasury exhausts its borrowing capacity on November 5, and some analysts place feel a government shut-down will occur Europe Greek debt relief negotiations should start soon; if protracted, the situation could renew concerns about Grexit. Growing concern that discontent in the U.K. will result in Brexit Central Banks The European Central Bank (ECB) and the Bank of Japan may both consider easing measures, but new dollar strength could create disruptive capital flows and exchange rate movements. 33 Possible Risks Remaining 2015 II New Normal factors at work: Destabilizing geopolitical events Geopolitical risks are very high now: The Wests relations with Russia are the worst they have been since the end of the Cold War The stand-off in Syria makes things even more dangerous Tensions are rising in the South China Sea Oil has remained cheap at the same time very unusual situation low oil prices have not provided the usual stimulus to the global economy One factor low oil prices reflect rapid buildup in supply from U.S. shale Second factor low oil prices sending a message about the possibility of further weakness in the global economy 34 Global Scenarios Alternative Scenarios to EIU October 2015: Major Risks I 37 EIU October 2015: Major Risks II 38 Geopolitical Risks Intensifying 39 Assessment of Key Risks As noted, the current consensus forecasts and scenarios are sensitive to a series of possible shocks/adverse developments. Adverse developments in one or more areas might result in increased instability, geopolitical tensions and/or negative linkages leading to lower growth rates: 1.Emerging Market Crisis 2.Instability from Oil Price Decline 3.African Debt Problems 4.Declining Defense Expenditures in the West 40 Key Risk: Emerging Market Crisis I Experts disagree about whether China faces a hard landing, but emerging markets pose a growing risk to the global economy Global markets very jittery now August 11, 2015, Chinese currency devaluation rattled global markets Since that time Chinese yuan has weakened then strengthened with government support Currency now just 2.5% lower than in August Global stock markets have had much bigger changes Dow Jones Industrial Average down 6.5% Shanghai Composite Index down 22% 41 Key Risk: Emerging Market Crisis II Crisis reflects long-standing concerns over Chinese economy including Overinvestment and excess capacity in manufacturing, Real estate and stock market bubbles fueled by easy money and leverage and An incomplete reform process that failed to place hard budget constraints on state enterprises The initial policy response by government was chaotic and opaque So those predicting a hard land landing have some support for their assessment 42 China: What Kind of Landing? 43 Key Risk: Emerging Market Crisis III Chinas Growth Story IMF forecasts Chinas growth rate at 6.8% (2015) and 6.3% for 2016 well below government's 7.0% This is well above many private forecasts High forecast based on several assumptions First, the nearly double digit growth in services and retail sales will continue confirming the rebalancing is occurring Second, policy will be better coordinated and communicated going forward Also monetary and fiscal stimulus will provide meaningful support to activity later this year Third the sharp slowdown in manufacturing will not cascade to the broader economy 44 Key Risk: Emerging Market Crisis IV Most likely the truth in China lies somewhere between hard landing and muddle through scenarios Other indicators of growth including sales, energy consumption and international trade tell a mixed story Many forecasters have marked down their China forecasts but still room for optimism What happens in China will have a significant impact on many commodity exporters Strong growth in Chinese services and a jobs supporting government stimulus package will not help commodity exporters Slow-down already being felt in Australia, Brazil and Argentina 45 Key Risk: Emerging Market Crisis V In countries where policies have been weak, markets have been brutal In Brazil which is also experiencing a political crisis, currency down 30% against the dollar since July Other countries such as South Africa and Indonesia also face significant currency pressures Even greater risks come from financial contagion There has been a rapid buildup in corporate debt and warnings of a banking crisis as a result of rapid credit growth in some emerging markets. Nonbank corporate debt has increased 500% over past decade to $23.7 trillion or around 90% of the GDP of these countries 46 Rising EM Debt Levels 47 Key Risk: Emerging Market Crisis VI Corporate debt defaults weigh directly on economic growth and can damage balance sheets of banks and the countries that stand behind the banks Much of this debt is linked to trade with China and Falling profits as well as Losses that could result from added currency volatility which is likely to dramatically add to burden of servicing this debt Could create financial distress throughout the emerging world Could lead to deflationary pressures which in turn would depress returns on investment Some worried that situation is similar to the collapse of Key Risk: Emerging Market Crisis VII On top of these concerns the most striking change in the IMFs outlook is an increased concern over the Sharp downward revision to the long-term growth prospects for emerging markets End of the commodity super-cycle and A reversal of capital inflows Signals a period of lower investment and weaker fiscal positions Results in reduced capacity to support growth Many cases optimism that existed following recession that emerging countries would rapidly see incomes converging with advanced industrial counties is gone. 49 Key Risk: Emerging Market Crisis VIII For the United States fragility in emerging markets is the critical risk By itself, softer Chinese growth and the 2.5% decline in the yuan since August 11 would only reduce growth by 0.1 or 0.2% However if other countries depreciate their own currencies against the dollar in response to pressures the broad based appreciation of the dollar could be significant Rough rule of thumb is that a 10% move in the traded weighted dollar reduces U.S. GDP by around 0.5% after a year Risks appear to have been an important factor in the Federal Reserve September decision to delay raising interest rates from zero Situation not likely to change anytime soon 50 Currency Depreciation in Emerging Markets 51 QE and Emerging Market Debt I 52 QE and Emerging Market Debt II 53 QE and Emerging Market Debt III 54 QE and Emerging Market Debt IV 55 EM Country Vulnearabilities 56 Key Risk: Oil Price Decline I 57 Key Risk: Oil Price Decline II 58 Russia and Falling Oil Prices I Facts: Energy is the largest single sector of Russian economy one quarter of total GDP, down form a third two years ago Energy exports account for about 68 percent of Russian trade Oil and gas revenues provide half the Russian governments official budget and uncounted but substantial amount of the unofficial funding that supports the countrys power structure As a result of the fall in oil prices Russian economy is predicted to decline by 3.5% this year with oil export revenue down by $95 billion 59 Russia and Falling Oil Prices II Immediate problem not sanctions imposed by the West The issue is economic Most of Putins 15 year reign has coincided with strong energy prices and growing production of oil and gas Resulting revenue ha enabled Kremlin to keep most people happy Businessmen, the military, the middle class of Moscow and St Petersburg, and most of wider population However, little done to prepare for the current downturn Economy has not been diversified A reserve fund but amounts small and will soon be drained if low oil prices continue Very limited improvement in infrastructure, particularly in the energy sector 60 Russia and Falling Oil Prices III Gazprom is set to produce less gas this year than at any time since fall of the Soviet Union Market share expected to drop by 30% this year Gas-to-gas competition Fed by increased flows of LNG has broken the traditional link between gas and oil prices, Is changing the structure of he market the Russians had taken for granted In addition Gazproms trading activities under attack from regulators in Brussels 61 Russia and Falling Oil Prices IV Situation in oil no better. Russia exports 6m b/d each worth 40% less than two years ago Large surplus of supply over demand Good reason situation will continue for several years and oil prices languish Sanctions and associated isolation of Russia because of Ukraine not immediate cause of problems, but they compound the countrys long term difficulties Russia needs to expand oil production into new areas but international oil companies in not hurry to invest with sanctions in place 62 Russia and Falling Oil Prices V Fears about Russian economy resulting in massive outflow of capital Exodus of capital since Ukraine crisis could reach $300 billion by end of 2015 Situation dangerous because options for Russian government are so limited Oil and gas markets being shaped by forces Putin can not control Downward cycle could take years to play out Even a resolution of Ukraine crisis would not restore Gazproms market share in western Europe Deals to sell gas from east Siberia to China and others make sense but will not make money for another decade 63 Russia and Falling Oil Prices VI Real risk is that economic discontent will force either existing Russian government or its replacement into harder political stance In many ways last 25 years of relatively stability are not the norm One of the major reasons for fall of the Soviet Union at the end of the 1980s was the collapse in energy prices Russia is weaker now that at that time. Fear is that Russia has much to gain from higher oil prices and that they also have the ability to destabilize the Middle East to bring that eventuality 64 Key Risk: African Debt I Debt growing problem in Africa Borrowing in dollars increasingly risky and expensive As local currencies depreciate on softening commodity prices, repayment costs soar Threatening added costs of up to 10.8 billion dollars March 5, 2015 Ghana announced plans for a $1 billion ten year Eurobond to repay part of its debt maturing in 2017 Extremely low and increasingly negative bond yields in developed economies encouraging capital flows to Africa Over past two years African states have issued 22 billion dollars in dollar denominated debt Almost as much as total sovereign issuance across the region in past nine years 65 Key Risk: African Debt II 66 Key Risk: African Debt III In last several months investors becoming more cautious Now oil exporters would have difficulty issuing debt on favorable terms In addition to possible slow oil price recovery, principle risk in dollar bond market is threat of earlier than expected U.S. interest rate increase Markets could shift very rapidly with borrowing rates increasing sharply Would make it considerably more difficult for countries to access international capital at affordable rates Oil exporters will be hit the hardest suffering high repayment costs due to currency volatility. The debt situation makes many African countries vulnerable to a fiscal crisis and internal unrest. 67 Key Risk: Falling Defense Expenditures I Military expenditures are only one gauge of military power. A given financial commitment may be adequate or inadequate depending on: The number and capability of a nations adversaries How well a country invests its funds and What it seeks to accomplish Nevertheless trends in military spending do reveal something about a countrys capacity for meeting threats Policymakers are currently debating the appropriate level of US military spending given: increasingly constrained budgets the winding down of involvement in Afghanistan and the potential threats posed by Russia and China 68 Key Risk V: Falling Defense Expenditures II Although there are a few exceptions there is a stinking contrast between rising defense expenditures in still growing economies and austerity-induced cutbacks elsewhere Robust growth in certain parts of the emerging world, largely Asia, means that these countries can increasingly afford to procure cutting edge defense technologies Increased military spending is a zero sum game and will inevitably generate arms races Certain countries China, India, and Russia take the view that their economic growth should be matched by equally impressive developments in their military capabilities. U.S. and European allies risk falling behind on defense expenditures unless they can revive growth and better control social expenditures. 69 Key Risk: Falling Defense Expenditures III 70 Key Risk: Falling Defense Expenditures IV 71 Key Risk: Falling Defense Expenditures V 72 Key Risk: Falling Defense Expenditures VI 73 Key Risk: Falling Defense Expenditures VII 74 Key Risk: Falling Defense Expenditures VIII 75 General Lessons Nobody Really Understands the World Economy economic outcomes hard to predict because world economy is continually in flux unknown unknowns will always be with us. That Goes Double for Financial Markets financial markets even more volatile than real economy Starting with the Dutch Tulip Bubble have had 350 years of financial crashes and panics unlikely to stop anytime soon each one that comes will take most people by surprise. The Battle of Financial Markets is Over: The Battle of State Finance Has Begun Speculators will test sovereign debt markets. Clear that governments can no longer do whatever it takes to fix economic problems. New, large and unpredictable risks now hang over the global economy. The US and its allies will face a long period of slow growth with contracting defense budets. This will require increased cooperation, coordination, and flexibility in adapting to a fundamentally altered budgetary environment 76 The End Questions? 77