We’ve just been through a year of enormous economic turbulence, and yet in most ways 2009 was mercifully quiet. The financial crisis hit the previous September and most things that could have gone wrong didn’t, allowing the world to focus on the digging out. 2009 saw no big geopolitical crises, no tussles with North Korea or Iran. The war on drugs in Mexico didn’t spill across the American border in a big way. Iraq didn’t blow up. There were no massive terrorist attacks (though Christmas saw a close call in the United States). No killer hurricanes, no huge earthquakes, and the H1N1 virus didn’t prove that threatening a pandemic after all. Governments around the world focused overwhelmingly on the domestic, putting tough policy decisions on hold. (And when they didn’t, as with Obama’s Afghanistan and healthcare plans, the results were seriously watered down, and actual policy risk was limited.)
This year, that’s going to be much harder to accomplish. If the 2009 top risks were first and foremost about developed states having their wits sufficiently about them to get through the financial crisis (with the US Congress leading the pack), as the world now emerges from recession the risks begin to shift to the challenges created by the emergence of a new global order--developed vs. developing states, the old unipolar system vs. the emerging non-polar one, and the old dominant globalized system of regulated free market capitalism vs. the growing strength of state capitalism.
The biggest risk for 2010 comes from the point at which these three trends converge: US-China relations. Simply put, 10 (percent unemployment in the United States) plus 10 (percent growth in China) does not equal 20. There’s been an enormous effort by the leadership of both governments to keep a functional US-Chinese relationship in place, much like the international approach to the G20, so that everyone could see the seriousness of the enterprise. But with the world’s principal actors under less immediate strain, there’s less pressure to keep up appearances. This year, the gloves start coming off.
Next up is Iran, where a deteriorating domestic and international environment combined with toughening sanctions pressure will create greater incentives for Tehran to provoke conflict. Along with the continuing (though limited) risk of Israeli military strikes on Iran’s nuclear sites, this is the year to watch for serious trouble emanating from the Islamic Republic.
We’ll also still see significant concerns within developed states this year--weaker states in Europe under massive fiscal pressure; financial regulatory reform in the United States; and the impact of a political revolution in Japan. A few surprises from emerging markets--Brazil’s a risk this year, as coming elections are more troubled than people expect. India-Pakistan risk resurfaces after years of quiet engagement (while Afghanistan, making headlines throughout the year, is effectively pushed as a top risk to 2011 by the US troop surge). Unemployment coupled with a spate of elections merit a spot for Eastern Europe in the top ten. And a host of domestic and international stresses puts Turkey on the list too, though barely.
Terrorism doesn’t make the list. It’s a growing global concern, but as a specific risk, it’s a fat tail. It can really upset markets when an attack hits, but short of that it’s principally a growing drag on global growth. Yemen is emerging as a focus for al Qaeda, and no doubt we’ll see significant fighting there...with direct American engagement. But short of Yemen actually failing as a state (unlikely in the nearest term) it won’t have significant impact globally--or even on neighboring Saudi Arabia. After many years, climate change finally sees its place on the top 10 list, mostly because of the growing policy and market impacts of the continued absence of effective international coordination on responses, a trend we’ll see more often in our increasingly non-polar world.
There are all sorts of country risks that don’t quite make the list--Colombia, Dubai, Malaysia, Mexico, Nigeria, and Thailand to name a few. Each is worthy of concern for those with direct exposures in these economies, but none will grow to the level of global risk in 2010.
And then some interesting red herrings. These include US and British financial centers, the death of which has been greatly exaggerated; Iraq, where investment and new oil will be a much bigger story than security risks; the Persian Gulf, which we generally like quite a bit (Dubai’s problems notwithstanding); and the dollar, where really slow and steady-ish still wins the race.
1 - US-China relations
The G2 was a stillborn idea, because Beijing doesn’t want the responsibilities, even though the United States pushed hard for this framework at the Obama-Hu Jintao summit in November. That won’t last in 2010. In the future, we’ll look back at that summit as the peak of the relationship, and we’ll see significant deterioration in US-Chinese relations in the coming year.
The problem isn’t Obama or Hu; both want to avoid ruffling feathers. But there are too many structural pressures for it to last. The United States is looking for more (and more responsible) international leadership from the Chinese--stakeholdership continues to be the mantra in policy circles. But as clearly evidenced on climate change during the Copenhagen summit, the Chinese have little national interest in taking a lead role. In 2010, we’ll see this trend also play out on nuclear proliferation, reform of rules of the road for international trade and commerce, cyber-security, and security in Afghanistan, Iraq, and beyond.
For Beijing, economic partnership with the United States looks a lot less attractive than it did just a couple of years ago. But China’s top leadership recognizes that it has little choice for the near term, which is why they are taking their time in building domestic demand and instead doing everything possible to maintain its share of global export markets. That means continuing domestic stimulus for the economy and tight controls over the exchange rate of the yuan. It also means a growing role for the state as lead actor and arbiter of the Chinese economy, and growing support for “national champion” Chinese firms, both at home and abroad.
With the uptick in domestic protections against Chinese exports (steel, tire tariffs), we’re just starting to see an American backlash to this Beijing response. The argument runs as follows: domestic industry subsidies and fixed yuan/dollar peg have allowed the Chinese government to draw wealth away from the US economy by allowing its export-focused industries to sell to the American consumer for artificially cheapened prices. By that logic, China hasn’t just been a free rider in the international system...but more directly on the US economy. Therefore, China’s plans for its immediate economic future are fundamentally incompatible with the vision of “global rebalancing” as laid out by Larry Summers and other Obama administration officials. This is the crux of the tension in the US-China relationship--by way of protectionist policies and slower consumer spending, the United States is rejecting China’s development model.
In 2010, a mid-term election year with high unemployment, labor and even some industry groups will lead the Obama administration to send the message that China’s economic policies cannot persist and will lay down the gauntlet with more tariffs on Chinese exports. We’ll see more intense politicizing of exchange rate policy (especially absent a significant rise in the yuan); investment policy tensions both in the United States (CFIUS) and in China (greater state preferences for local firms); China-bashing when Obama pushes cap and trade in the Senate; growing trade tensions (especially on steel); and issues involving cyber-security. And if any new “product safety” scandal emerges involving Chinese manufactured goods in the middle of those tensions, we’ll also see a populist American push against goods "made in China."
A recent Pew-CFR survey reported that 44% of Americans believe China is now the “world’s leading economic power.” Just 27% say it’s the United States. In 2008, we saw the last US presidential election in which the overwhelming majority of voters didn’t know or care where the candidates stand on China. The shift begins this year.
2 - Iran
By far the biggest purely geopolitical risk in 2010 comes from Iran. Its government now faces growing pressure on three fronts. At home, the regime has had a tough time since last June’s presidential election; hardliners had initially consolidated, but are now under intensifying pressure as domestic protests continue. Regionally, Tehran has lost considerable influence, with elections in Lebanon turning against Hizbullah, rising Iraqi nationalism making it harder for Tehran to exert influence upon their principal historic competitors, and Iran’s financial outpost in Dubai put at risk by the growing influence of Abu Dhabi.
Globally, Iran faces a considerably tougher sanctions regime over its nuclear program, a push spearheaded by the United States, Europe, and Japan, with even Russia and China unhappy over Tehran’s aggressive rhetoric. A Western push for negotiations will continue, but divisive local politics and insufficient leadership coordination make it very unlikely that Iran’s leadership could reach a negotiated settlement even if it wanted one. And it doesn’t. Even under considerable domestic pressure, the hardliners in charge of the regime will continue to try to buy time to achieve their nuclear ambitions.
That’s why the government is likely to overreact to sanctions when they hit. 2010 carries the highest risk to date of Iranian provocation in the region, in the form of harassment of shipping in and around the Strait of Hormuz, support for radical organizations in neighboring countries, and instigation of trouble for Iraq and other neighbors in demonstrations of muscle. The Iranian regime looks increasingly like a cornered, wounded animal. In 2010, it’s likely to act like one.
Israeli military strikes have actually become less likely--certainly for the first half of the year as sanctions are put in place. Faced with strong opposition from the Obama administration (even as it uses the threat of strikes to gain support for sanctions and to pressure Tehran), mounting intelligence challenges on the location of key Iranian targets, and recognition of the military limitations of Israeli strikes, some Israeli government officials now privately are beginning to discuss how to cope with an eventual nuclear Iran as much as the nature of its "existential threat.” Still, the perceived Israeli national security issue is enormous. Looking toward the final months of the year, the Israelis remain an important question mark.
Over time, if the regime in Tehran remains in power, the Iran danger will become more diffuse and start to look more like North Korea. It’s clearly a significant long-term negative for global stability. Though for Iran itself, by 2011, we’ll probably see a bunch of countries start thinking about how they’d like to start investing there, even as the Western powers seek to prolong sanctions.
3 - European fiscal divergence
Political risk returns to the Eurozone in an important way this year, with the consequent blurring of the distinction between “mature” and “emerging” markets. Fiscal policy coordination has been eroding for some time, and member state political processes are highly uneven.
Greece, Ireland, Spain, Portugal and Italy face the most complex fiscal challenges, and while Ireland appears ready to make aggressive budget cuts, the others are reluctant. Defaults remain possible, since EU support should not be considered automatic. But policy changes will have far-reaching implications even without a default, with a new set of risks arising from fundamentally new political drivers at play in the Eurozone--and a consequent growing importance of political factors in healthier European economies. We’ll see this arise as tax structures are revisited, governments continue to use fiscal tools to support specific firms and sectors, and as policymakers struggle to adapt domestic politics to the more pressing public financing challenges elsewhere in the Eurozone.
There are related risks in Eastern Europe, particularly if European Central Bank (ECB) liquidity measures are curtailed. This has long been, and still is, a major concern for Austria, given its bank exposure. This is compounded by overlapping exposure in economies where Greek banks are systemically important. In this vein, if one of the big Western European banks active in Eastern Europe gets in trouble, a rescue effort would be extremely messy.
4 - US financial regulation
On balance, 2010 is looking like a tougher year for President Obama than 2009 proved to be. Going into the new year, he has succeeded in kicking Afghanistan and climate change down the road, but pulling off a real policy success on either still looks unlikely. Unemployment remains high as the country pulls weakly out of recession and mid-term elections appear on the horizon. While Obama’s popularity may take a beating, the coming year will see considerably less actual domestic policy risk in the United States than in 2009. But the exception is in the process of financial regulatory reform. That’s likely to be a tougher issue than people expect.
The reform package that passed the House of Representatives is comprehensive, though it will be moderated in the Senate, where for the first time under Obama a serious bipartisan effort is being undertaken. Either way, substantial change is afoot--more far-reaching than anything we’ve seen since the Great Depression. The result will be a structure put in place to monitor and address systemic risk, largely self-financed from the financial community, as well as changes on many other issues, ranging from derivatives regulation to the proper role of the Federal Reserve Bank.
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