The seven tail winds out to de­rail global econ­omy

The Pak Banker - - OPINION - Nouriel Roubini

THE ques­tion I am asked most of­ten nowa­days is this: Are we back to 2008 and an­other global fi­nan­cial cri­sis and re­ces­sion? My an­swer is a straight­for­ward no, but that the re­cent episode of global fi­nan­cial mar­ket tur­moil is likely to be more se­ri­ous than any pe­riod of volatil­ity and risk-off be­hav­iour since 2009. This is be­cause there are now at least seven sources of global tail risk, as op­posed to the sin­gle fac­tors - the Eu­ro­zone cri­sis, the Fed­eral Re­serve "ta­per tantrum," a pos­si­ble Greek exit from the Eu­ro­zone, and a hard eco­nomic land­ing in China - that have fu­elled volatil­ity in re­cent years.

First, wor­ries about a hard land­ing in China and its likely im­pact on the stock mar­ket and the value of the ren­minbi have re­turned with a vengeance. While China is more likely to have a bumpy land­ing than a hard one, in­vestors' con­cerns have yet to be laid to rest, ow­ing to the on­go­ing growth slow­down and con­tin­ued cap­i­tal flight.

Se­cond, emerg­ing mar­kets are in se­ri­ous trou­ble. They face global head­winds (China's slow­down, the end of the com­mod­ity su­per cy­cle, the Fed's exit from zero pol­icy rates).

Many are run­ning macro im­bal­ances, such as twin cur­rent ac­count and fis­cal deficits, and con­front ris­ing in­fla­tion and slow­ing growth.

Most have not im­ple­mented struc­tural re­forms to boost sag­ging po­ten­tial growth. And cur­rency weak­ness in­creases the real value of tril­lions of dol­lars of debt built up in the last decade. Third, the Fed prob­a­bly erred in ex­it­ing its zero in­ter­est rate pol­icy in De­cem­ber. Weaker growth, lower in­fla­tion (ow­ing to a fur­ther de­cline in oil prices), and tighter fi­nan­cial con­di­tions (via a stronger dol­lar, a cor­rected stock mar­ket, and wider credit spreads) now threaten US growth and in­fla­tion ex­pec­ta­tions. Fourth, many sim­mer­ing geopo­lit­i­cal risks are com­ing to a boil. Per­haps the most im­me­di­ate source of un­cer­tainty is the prospect of a long-term cold war - punc­tu­ated by proxy con­flicts - be­tween the Middle East's re­gional pow­ers, par­tic­u­larly Saudi Ara­bia and Iran. Fifth, the de­cline in oil prices is trig­ger­ing falls in US and global eq­ui­ties and spikes in credit spreads. This may now sig­nal weak global de­mand - rather than ris­ing sup­ply - as growth in China, emerg­ing mar­kets, and the US slows.

Weak oil prices also dam­age US en­ergy pro­duc­ers, which com­prise a large share of the US stock mar­ket, and im­pose credit losses and po­ten­tial de­faults on net en­ergy ex­port­ing economies, their sov­er­eigns, state-owned en­ter­prises, and en­ergy firms. As reg­u­la­tions re­strict mar­ket mak­ers from pro­vid­ing liq­uid­ity and ab­sorb­ing mar­ket volatil­ity, ev­ery fun­da­men­tal shock be­comes more se­vere in terms of risk-as­set price corrections.

Sixth, global banks are chal­lenged by lower re­turns, ow­ing to the new reg­u­la­tions put in place since 2008, the rise of fi­nan­cial tech­nol­ogy that threat­ens to dis­rupt their al­ready-chal­lenged busi­ness mod­els, the grow­ing use of neg­a­tive pol­icy rates, ris­ing credit losses on bad as­sets (en­ergy, com­modi­ties, emerg­ing mar­kets, frag­ile Euro­pean cor­po­rate bor­row­ers), and the move­ment in Europe to "bail in" banks' cred­i­tors, rather than bail them out with now-re­stricted state aid. Fi­nally, the Euro­pean Union and the Eu­ro­zone could be ground zero of global fi­nan­cial tur­moil this year. Euro­pean banks are chal­lenged. The mi­gra­tion cri­sis could lead to the end of the Schen­gen Agree­ment, and (to­gether with other do­mes­tic trou­bles) to the end of Ger­man Chan­cel­lor An­gela Merkel's govern­ment.

More­over, Bri­tain's exit from the EU is be­com­ing more likely. With the Greek govern­ment and its cred­i­tors once again on a col­li­sion course, the risk of Greece's exit may re­turn. Pop­ulist par­ties of the right and the left are gain­ing strength through­out Europe.

Thus, Europe in­creas­ingly risks dis­in­te­gra­tion. To top it all off, its neigh­bour­hood is un­safe, with wars rag­ing not only in the Middle East, but also - de­spite re­peated at­tempts by the EU to bro­ker peace - in Ukraine, while Rus­sia is be­com­ing more ag­gres­sive on Europe's bor­ders, from the Baltics to the Balkans.

In the past, tail risks were more oc­ca­sional, growth scares turned out to be just that, and the pol­icy re­sponse was strong and ef­fec­tive, thereby keep­ing risk-off episodes brief and restor­ing as­set prices to their pre­vi­ous highs (if not tak­ing them even higher).

To­day, there are seven sources of po­ten­tial global tail risk, and the global econ­omy is mov­ing from an anaemic ex­pan­sion (pos­i­tive growth that ac­cel­er­ates) to a slow­down (pos­i­tive growth that de­cel­er­ates), which will lead to fur­ther re­duc­tion in the price of risky as­sets (eq­ui­ties, com­modi­ties, credit) world­wide. At the same time, the poli­cies that stopped and re­versed the doom loop be­tween the real econ­omy and risk as­sets are run­ning out of steam.

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