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Global Economic Perils:

Black Swans Alighting?


Black Swans Alighting?


The global economy is just starting to recover from the 2008-2009 financial crisis, but dark clouds that could send the economy spiraling downward remain on the horizon.



Black Swans Alighting?

By Hsiang-Yi Chang
From CommonWealth Magazine (vol. 449 )

Enterprises and individuals around the globe, from international organizations and leading financial authorities to Taiwan's top electronics companies and the average investor, are all bundles of nerves as they stand ready for battle in the second half of 2010. They are wary of unpredictable and destructive "black swans," which have repeatedly appeared recently to stir up trouble.

What are these "black swans"? According to New York University professor Nassim Taleb, the author of the 2007 best-seller The Black Swan, the term refers to "high-impact, hard-to-predict, and rare events that are beyond the realm of normal expectations in history, science, and technology."

Taleb believes "Black Swans" appear frequently because governments, companies and individuals have all fallen into the habit of taking the prosperity they have experienced for granted while remaining individually and collectively blind to uncertainty and hidden structural risks.

In an interview with CommonWealth Magazine, World Bank chief economist Justin Yifu Lin buttressed Taleb's argument, warning in an imposing tone: "The global economy is recovering, but it is still structurally weak. If different hidden risks are not accurately identified, a second recession could become a reality."

So what black swans are likely to appear in the second half of 2010? Could one of them cause the new engine of global economic growth – China's economy – to hit the skids for a second time? Based on interviews with experts at home and abroad, CommonWealth Magazine has identified the five existing "black swans" that pose the greatest threat to the world economy, and the structural risks that constitute their underlying causes.

Black Swan 1: The Sovereign Debt Crisis

From Iceland and Dubai to more recently Greece and Hungary, news of countries defaulting on their sovereign debt obligations or being on the verge of bankruptcy has dominated the headlines in recent months, leading to bouts of volatility in global stock markets.

Even though different international organizations have jumped to the rescue, and Hungary's debt crisis proved to be a false alarm, the frequent scares have punctured the myth that "countries can't go bankrupt." They have also revealed that the strategy of piling up new debt to service old debt to cope with the financial meltdown in late 2008 has created serious structural problems.

"The fundamental problem behind the financial crisis in 2008 was private debt. Now the threat to the global economy comes from sovereign debt," says Wu Ho-Mou, a Taiwan native who is now the deputy director of Peking University's National School of Development.

The Lausanne-based International Institute for Management Development (IMD) released in mid-May a new debt-stress index as part of its annual World Competitiveness Yearbook to measure the magnitude of the public debt issue for each nation. It looked at current debt levels and average economic growth rates over the past 10 years to calculate how long countries would need to lower their public debt burdens to below the "bearable" ratio of 60 percent of GDP. The study found that 17 of the 58 economies measured would need more than nine years to return their public debt to "bearable" levels. (See Table)

Japan's situation was the most serious, with the country expected to need 74 years to bring debt levels down to acceptable levels. Even countries such as the United States and Britain, which are considered to have a greater capacity to repay debt, were still projected as needing 17 to 20 years to reach the 60-percent threshold.

The IMD used the word "sinners" to describe heavily indebted countries. According to the institute's report on the debt-stress index, the average debt burden of the G20 nations will climb from 76 percent of their combined GDP in 2007 to 106 percent this year. "Although the ‘great recession' is over, the consequences of the crisis will continue to be felt for quite some time," the report warned.

World Bank economist Andrew Burns warned recently that if heavily indebted high-income countries cannot return fiscal policy back to a sustainable level and thus trigger another credit crisis, it will drag down their domestic consumption and create a major spillover effect by hurting the exports of emerging countries. Under that scenario, the global economy will hit bottom for a second time.

Black Swan 2: Surplus Currencies Losing Their Value

Because of the Greek debt crisis, the euro has plunged more than 15 percent over the past half year against the U.S. dollar. Of 25 prominent economists recently interviewed by the British media, half believed that the euro will disappear within the next five years. That view would have been considered heretical just over two years ago, when the greenback was getting weaker and most analysts were recommending the long-term purchase of the euro as a hedge.

The strange and unpredictable swings seen today in international foreign exchange markets are even greater than before. But the real danger lurking behind this "black swan" is the serious crisis of confidence among investors in major global currencies like the euro, the U.S. dollar and the Japanese yen.

"In the past, I used to laugh at my employees for being rubes when they took their pay and bought gold chains to wear," says a Taiwanese businessman surnamed Wu who has worked in Ho Chi Minh City for over 15 years. But last week, Wu could no longer resist the temptation. He converted 40 percent of the U.S. dollar profits he made on a shipment overseas into gold through private channels, and stored it in a vault.

Cheng-Mount Cheng, vice president and economist with Citi Taiwan, said the high price of gold in fact reflects investors' lack of confidence in major international currencies.

"In international trade, the U.S. dollar and other international currencies still have irreplaceable functions. But in terms of savings, a growing number of people are distrusting currencies and diverting their funds to the gold and precious metals markets as a hedge," Cheng says.

He explains that the key to the crisis in confidence in the major currencies is the expansionary monetary policy favored by many countries' central banks during the credit crunch and the lack of a plan to phase the policy out.

"It's like a patient under observation in an intensive care unit. The disease (economic figures) has already taken a turn for the better, but the doctor is slow to allow the patient to transfer to the regular inpatient ward or be discharged. That inevitably leads people to wonder whether the patient has any other diseases," Cheng says. He estimates that the U.S. Federal Reserve will begin raising interest rates in the second quarter of 2011 and says that only then will the currency crisis noticeably improve.

Black Swan 3: Hot Money Causing Bubbles in Emerging Markets

Following the financial crisis, Asia's emerging markets and countries rich in natural resources played a major role in re-igniting global economic growth. But with loose monetary policies being kept in place in Europe and the U.S., the massive flow of "hot money" had no place to go and began flowing into countries with good future prospects as a hedge and money maker. These capital movements immediately created the problems of asset bubbles and imported inflation.

Recently, Asia's major emerging markets have begun to raise interest rates or allowed their currencies to appreciate against the U.S. dollar (Singapore for example), exposing the serious problems they are facing.

Policy makers in the central governments of China and other emerging markets face a serious dilemma. The Economist has observed that India, one of the major emerging Asian economies, faces nearly double-digit inflation, and this has compelled its central bank to raise interest rates. Compared with South Korea, which has maintained interest rates at a stable level, and Eastern European countries that are still reducing rates, India is offering nearly 5-percent interest on savings deposits. That could actually trigger a wave of international hot money flooding into India, causing a new round of inflation.

China has tried to rein in bank lending and put in place other policies designed to cool the property market and keep a lid on interest rates, but those same policies will exacerbate the risk of more non-performing loans in the banking sector.

Fundamentally, hot money speculators should bear the greatest responsibility for this, says Morgan Stanley Asia chairman Stephen S. Roach. Because the expansionary monetary policies of Europe and the United States are seen as a panacea for the crippling recession, and countries have been reluctant to phase them out, hot money has stampeded into risky assets and emerging markets, creating a state of disorder.

Roach believes that to resolve the asset bubble threat fueled by hot money, emerging economies need to increase interest rates and also strengthen incentives for capital to move into fixed investment (i.e. investment in tangible capital goods). He also suggested that the United States, as the supplier of the world's leading reserve currency, should establish a plan as quickly as possible to phase out its loose monetary policy.

Black Swan 4: Overcapacity

The World Bank's Justin Lin thinks that the greatest risk for the global economy today is overcapacity, a problem that some studies suggest could persist until 2014. Industrial production began losing steam in August 2009, and the same trend is now afflicting emerging economies, reflecting a possible weakening of demand, which is critical for sustaining growth.

One way to boost demand growth is through stimulative fiscal policy, but such policies tend to exacerbate government debt. Thus, when some countries phase out the stimulus packages used to counter the global economic meltdown, aggregate demand could contract even further.

With consumption in Europe and the United States remaining lackluster and China's transformation into an economy oriented toward domestic demand instead of exports still a long way away, the problem of overcapacity may not just affect old economy manufacturers, but the high-tech sector as well.

AU Optronics executive vice president Paul Peng and iD SoftCapital Inc. president Philip Peng both consider overcapacity to be a hidden concern that Taiwan's high-tech sector will confront in the future.

"But because the high-tech sector benefits from the high flexibility of its products, and because of the momentum created by international brands launching new products, the problem of overcapacity is not serious right now," says AUO's Peng.  

iD SoftCapital's Philip Peng adds that Taiwan's two main high-tech benchmark sectors – IC design and flat panels – will not face overcapacity problems this year. But because the industry's end products, such as consumer electronics, face an environment of stagnant demand, he anticipates that eventually companies will resort to cutthroat pricing strategies to seize market share. As a result, suppliers will have trouble increasing prices, and with base wages in China on the rise, high-tech vendors will likely have their profits squeezed, Philip Peng predicts.

Black Swan 5: A Lost Decade for Investment Banks

The global manufacturing sector may be facing the severe test of rising wages in China, but Wall Street's financial giants are looking at an even more imposing challenge.

In April, the U.S. Securities and Exchange Commission (SEC) charged Wall Street leader Goldman Sachs with fraud in structuring and marketing credit derivatives tied to subprime mortgages, shocking the global financial sector. Since then, the SEC and U.S. Department of Justice have opened a broader investigation into similar practices at eight other investment banks. At the same time, the Obama administration has pushed what is described as the most sweeping overhaul of financial regulation since the Great Depression, and the U.S. House and Senate are currently reconciling separate pieces of legislation they passed on the issue to create a final financial regulation bill.

According to analyst estimates, based on the various possible final versions of the bill, Wall Street investment banks could face losses in profitability of 10-30 percent in the next one to three years.

"This is the end of Wall Street, in a way," said former Lehman Brothers vice president Lawrence G. McDonald in an interview with CommonWealth Magazine. After the venerable investment bank went bankrupt, McDonald wrote a book titled A Colossal Failure of Common Sense on how the company skirted the law and acted unethically in reaping massive profits before collapsing.

McDonald believes that once tougher financial regulations are put in place, Wall Street will be unable to match the levels of profitability seen in the years leading up to 2008 for at least a decade, which also means that the artificial prosperity created in capital markets by the massive trading of derivatives also has little chance of resurfacing.

As 2010 enters the second half of a critical year in which the global economy went from contraction to growth, there remains a flock of black swans masking diverse structural problems left behind by the subprime mortgage crisis and the global financial crisis.

It is impossible to predict what kind of impact these five swans will have on the global economy. But what is certain is that from governments and corporations to the average individual, the only way to survive future tests will be to face the risks head on with patience and flexibility.

(Additional interviews by Sara Wu, Huang Chao-yung)

Translated from the Chinese by Luke Sabatier