Sept 12, 2006
Serhan Cevik (London)
Five years after 9/11, the world is still searching for peace and stability. The world economy, as our chief economist Stephen Roach argues, is in the early stages of rebalancing, after going though a period of historically low real interest rates and above-trend growth (see On the Road to Global Rebalancing, September 8, 2006). Addressing global economic and financial imbalances is a daunting challenge — like solving a Rubik’s cube that requires simultaneous realignment of a range of variables. However, even an outright success at such a multi-dimensional task is not necessarily enough to achieve sustainable stability, since political challenges of the post-9/11 era represent yet another Rubik’s cube. When al-Qaeda terrorists flew the hijacked planes into the Twin Towers of the World Trade Center five years ago, they did not just commit a terrible act of mass murder, but also opened a catastrophic Pandora’s Box in the Middle East and ushered in an era of greater uncertainty around the world. Unfortunately, the ‘West’ has failed to comprehend and tackle the root causes of popular resentment on which jihadi ideology and global terrorism thrive, in our view. And the consequences of paradoxical unilateralism — creating a multipolar (dis)order of ‘us’ versus ‘them’ — have just begun to unfold and may possibly result in new fragilities.
With tensions soaring in the Middle East, global terrorism is on the rise. Some observers assess the post-9/11 performance with financial barometers like stock market indices or the rate of economic growth and conclude that the terrorist attacks of 9/11 and what has followed afterwards have not dented economic progress on a global scale. In our view, this line of reasoning is a misguided approach and overlooks the underlying weaknesses. As a matter of fact, despite financial euphoria and strong growth driven by cheap money in the post-9/11 period, the world has become far more polarised and dangerous, especially with the war in Iraq changing the geo-political context and contours of the Middle East. As Iraq lies in ruins and struggles with a sectarian civil war, the whole region is becoming further polarised along the Shia-Sunni divide and radicalised in terms of political discourse. Even Afghanistan, after early cheers of victory, is now in a state of flux, to say the least, and remains in a fragile condition. More recently, the stand-off with Iran and the conflict between Israel and Lebanon have kept strengthening messianic, radical forces that reach beyond national and ethnic identities. And the result is a recurrent cycle of violence, leading to an exponential increase in the number of reported terrorism incidents in the world. For example, according to the US Department of State, there were 11,111 terrorist attacks that caused 14,602 deaths last year, compared to 205 attacks killing 725 in 2002. This is an increase of over 5,300% in the number of terrorist attacks and almost 2,000% in the number of deaths in three years. Even if we use a narrower definition of terrorism developed by RAND/MPIT, the picture does not change much, with a cumulative 1,600% increase in the number of deadly attacks in the years since the war in Iraq. Although the cycle of political tensions and violence is strong, reversing it is not impossible, in our view, as long as the root causes are correctly identified and appropriately addressed.
A comprehensive settlement between Israel and the Palestinians is the most important step. Political breakthroughs — like the fall of Berlin Wall and the Oslo agreements between Israel and the Palestinians — made the 1990s one of the most prosperous and peaceful decades in history. Unfortunately, historical baggage proved to be too heavy for some and the peace process failed in 2000, triggering a shocking wave of violence in the region and keeping the unresolved conflict as a major source of popular resentment and extremism. This is why even though there will always be marginal groups — on all sides — threatening peace and stability, restarting the peace process is the most important and immediate step in the right direction. However, we believe that its endurance requires a comprehensive settlement between Israel and the Palestinians, and cannot be achieved through unilateral moves or military campaigns.
Poverty and social frustration aggravate the threat of global terrorism. The benefits of globalisation come with the challenges of increasing complexity. In today’s world, no one has the luxury of ignoring other peoples’ problems, which sooner or later become a common problem (see The Death of Doha, August 10, 2006). Take, for example, the issue of global poverty, which is not just a humanitarian concern, but also a threat to stability at large. Even though not every terrorist comes from an impoverished background, poverty and social frustration under authoritarian regimes increase the tendency to support/join radical movements and terrorist organisations. This is certainly the case for much of the Middle East, where socio-economic under-development and educational deficiencies have led to popular disillusionment and militant rhetoric. Therefore, we believe that developing liberal democracies, albeit with obvious transitional challenges like the rise of politico-religious groups, is still the best hope for peace and stability in the long run.
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Long Live Idiosyncratic Risk
Sept 12, 2006
Gray Newman (New York) and Luis Arcentales (New York) and Daniel Volberg (New York)
Ever since the sell-off in risky assets began in May, emerging market watchers have been divided on whether the move represented an opportunity to add exposure or a warning sign of what is to come. The quick reversal and rebound in late June and July caught many of the most nimble players off guard. And then, just as the sense that ‘Goldilocks’ — that global growth was neither too hot nor cool and hence inflation was not a risk — was beginning to settle in, we have seen another stumble in recent weeks.
How to make sense of all of this? We would make three observations in an attempt to make sense of the recent ups and downs of the market.
First, the fundamentals in many emerging market credits have improved. There is a genuine transformation taking place at the macro level in some of the most important economies, particularly in Latin America, which for too long has been the home of the many of the emerging markets’ ‘basket cases’. And the improvement in fundamentals has been constantly cited by emerging market boosters who have watched as an abundance of liquidity in recent years has increased risk appetite and interest in the emerging markets’ story.
It matters to us, for example, that Brazil’s new record trade surplus — just above $46 billion in the 12 months ending in August — is producing a sizeable current account surplus. It matters as well that Mexico is running a modest current account surplus during the first half of the year.
We highlight the balance of payments statistics not because we are believers that emerging economies should aim for current account surpluses. On the contrary, most countries need a meaningful investment boom that is likely to produce a financeable deficit. But in a world where the greatest risk remains that we could be faced with a downturn in liquidity, having smaller or non-existent financing needs reduces vulnerability.
Furthermore, the growth in reserves and the moves to put external debt on the list of extinct species in a number of countries can also serve to reduce vulnerability in the event of a sudden reduction in liquidity. The fact that Brazil's net external debt (net of reserves) is now zero and that the authorities continue to buy back the existing gross debt matters a great deal for credit markets. The move in August when Mexico announced that it was paying off over $9 billion of lnter-American Development Bank and World Bank loans even as it was retiring another $3.4 billion in external bonds helped its debt to GDP in one month alone fall from 7% to 5.4%. It is little wonder then that external debt spreads in many emerging markets have approached and then set new record tights even as global markets continue to gyrate with an ‘on again, off again’ focus on the Fed’s actions.
…and differentiation as well
But, second, for every story of improvement, the emerging markets are still littered with vulnerable credits. For every emerging market with a current account surplus, there appears to be another with a looming deficit. Russia and Brazil may be darlings on the balance of payments side, as well as Venezuela and the Philippines, but then there is India, South Africa, Turkey and Hungary with worrisome imbalances at precisely the time when global liquidity is receding.
The fiscal vulnerabilities in emerging markets appear greater still. While Russia and Chile get high marks for sizable fiscal surpluses, for every emerging market with a budget surplus, there are a host of countries with burgeoning fiscal deficits. Turkey, Poland, Hungary and India have all been running fiscal shortfalls ranging from 4% to 8% of GDP in the last three years.
And the risks on the fiscal front are probably greater still than a simple ranking of budget balances as a percentage of GDP. We have built a series of stress tests to measure just solid the fiscal performance has been among the ‘who’s who’ of emerging markets. The results are worrying.
One test attempts to measure how pro-cyclical the nature of the public finances is: the higher the country’s pro-cyclical rating, the more vulnerable it is likely to be to a slowdown in growth. To find out just how pro-cyclical fiscal balances are in different emerging economies, we estimated how a deviation, relative to the long-run trend, in the country’s level of economic activity would affect its fiscal balance. Poland and Peru have the most pro-cyclical fiscal balances and are thus most vulnerable to a global slowdown: when activity in these two countries declines by 1% relative to the trend, their fiscal balances (as a fraction of GDP) are expected to worsen by 0.1% and 0.08%, respectively. By contrast, Israel and the Philippines run the most counter-cyclical fiscal balances and would thus be expected to fare better during lean times, as these governments trim spending more effectively, easing the pressure on their fiscal coffers.
Technicals versus fundamentals
Third, at times it seems that technicals rather than the promising fundamentals or the worrisome vulnerabilities of the asset class matter the most. Many of the most nimble players appeared to have gotten out of large emerging markets positions in May and June and even early July when concerns over tightening global liquidity and aftershocks from the Bank of Japan were hitting the market. And then, they missed the rally. No sooner did that realization set in, and we began to see a host of funds under budget begin to chase the market back up. And then in early September, with stronger labor cost data in the US hinting at the possibility of another inflation scare ahead, that strategy began to lose favor.
It is difficult to know whether the current pullback is set to morph into a more serious downturn in risk appetite. But there is one thing that we would argue that we do know: over the long run, the fundamental differences among economies are likely to matter. And in a world still facing the risk of a further withdrawal of liquidity, we are likely to see further discrimination in investor attitudes towards emerging markets. There are countries which have taken advantage of the abundance of liquidity to reduce external indebtedness and wean themselves off the ‘hot money’ of short-term capital inflows by targeting foreign direct investment, and there are countries where the financing needs from both a balance of payments position and fiscal position have actually grown. In good times, those distinctions tend to blur. In challenging times, by contrast, those distinctions are likely to be amplified. Long live idiosyncratic risk!
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