2016 CCMR Executive - PowerPoint Presentation

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2016 CCMR ExecutiveCourse in Decision MakingNaval Postgraduate School November 8, 2016Dr. Robert E. Looneyrelooney@nps.edu

Global Tensions

and Economic Security Slide2

Outline Part I: The Global Economic EnvironmentOverview of the 2008-09 CrisisPatterns of RecoveryThe Current Situation – Major Economic TrendsForecastsPart II: Leading Themes/Major RisksGeopolitical/Security ThreatsBrexit and Anti-GlobalizationOil Price Decline – Debt Problems, Russian Crisis, OPEC AgreementEmerging Market Difficulties – China ScenariosU.S. Long Term Budget Patterns – Declining Defense ExpendituresDeclining Western Defense Expenditures

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Main Theme: The Security Trilemma3Slide4

The Global Crisis, 2008-09

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Global Financial Crisis: Initial Security Concerns

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Economic Crisis and Security Threats“The global recession is America’s 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)

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Global Economy Overview IThe Changing Global SystemBefore the 2008-09 crisis, the main feature of the global economy was its rapid integrationHas continued, but at a much slower pace since the crisisIn the post- 2008-09 period:Economic policies largely set at the national level to benefit domestic economyExternal effects -- these policies are increasingly affecting other economies in an adverse wayThese effects particularly important in the monetary/financial sector due their potential for creating increased volatility in:Capital flowsAsset pricesInterest rates, exchange rates, and credit availability.

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Global Economy Overview IIThis instability has been compounded by growth models in many advanced economies based on:Excess monetary expansion/credit, andDebt-driven domestic aggregate demandAlso, structural flaws such as rigid labor markets, limited competition and inflexible prices, especially in Europe have led toInstabilityAn on-going crisisLarge negative shock to the real economyEmerging economies were subsequently affected by Credit tightening (including trade finance)Rapid declines in exports

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Global Economy Overview IIIIn the United States, unconventional monetary policyLowered cost of credit for debtors and those seeking to borrow for business expansionCame at the at expense of savers – lower interest ratesDid not work well because investment constrained by deficient domestic demand relative to capacity Savers sought higher returns in emerging economies Result: increases in credit and causing upward pressure on exchange rates and asset prices in Emerging Markets (EMs)EMs responded withLimits on capital inflowsReserve accumulation and measures to restrict credit and restrain asset-price inflation

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Global Economy Overview IVSituation changed in May 2013 when U.S. Federal reserve indicated it might taper its purchase of long-term assetsAsset prices shifted and in emerging economiesCapital rushed out,Caused credit markets to tighten, andExchange rates to fallResulting in a slowdown in short-term growth.Volatile capital reversals may have longer term adverse effects – although not clear at this pointChina the exception:While China’s output is affected by advanced country economic performance – financial system largely isolatedCapital account less open, foreign currency reserves of $2.5 trillion mean exchange rate is controllable

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Global Economy Overview VDecentralized policy and growing externalities will result in a partial de-globalizationNot a good idea to run persistent current account deficits and become dependent on (temporarily) low-cost foreign capitalOpen capital accounts may be replaced by rules-based constraints on financial capital flowsLesson from crisisPattern of accumulating reserves via current account surplus will be more pronounced in order to manage exchange ratesPublic purchases of domestic assets to stabilize asset prices will become increasingly common.Successful countries will be those who learn to live with growing policy interdependency without much policy coordination

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Crisis Has Accelerated Changes in World GDP

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Decline of the G-8

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Current Global Patterns IToday world economy is characterized by divergenceAs the charts indicated, while growth was centered in the advanced world in the 1970s, 1980s, and 1990s, more recently it has moved to emerging economiesAccording 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 economiesThe 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

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Current Global Patterns II

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Current Global Patterns III

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Current Global Patterns IV

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Current Global Patterns V18Slide19

EM/DM Growth Convergence19However since 2009, EMs as a group are converging on the advanced countries at a slower pace.Slide20

Today’s Policy EnvironmentPolicy makers are in a bind in many countriesIn the Eurozone and Japan they are still trying to find ways to stimulate demand and avoid deflationIn the U.S. interest rates beginning to increase, but there is widespread concern that any movement back to normal might trigger financial turmoilHowever leaving monetary policy loose will encourage excessive borrowing which may create bubbles and another financial crashIn emerging markets the need is to push forward on structural and governance reforms to labor and product markets as well as education and social security to enable more secure and rapid growthNot easy and mistakes are certain to happen.The economic environment in many parts of the world is thus quite fragile with forecasts increasingly pessimistic.

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Current Situation Q4 2016 IGlobal Baseline: Situation characterized by sluggish growth, low yields, little underlying inflation.Growth remains heavily reliant on the global consumer and major central banksBoth coming under strainPolicy mix still off targetUncertainty over direction of policy continues to weigh on investmentOnly a decisive turn toward fiscal easing or certain types of structural reform (taxes, labor) are likely to break cycle of stagnationLittle sign of optimism in that regardMonetary tools still provide bulk of current stimulus, but appear to have hit diminishing returns with negative interest rates.

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Current Situation Q4 2016 IIFiscal policy less austere, but hardly at full throttleGovernments have generally eased up on austerity measuresThe U.S. may join China, Canada, and Japan in moving to an expansionary policy, but not until after the electionThe UK’s forthcoming fiscal package will be significant, but benefits largely offset by impact of uncertainty over Brexit negotiations with the EUPolicy uncertainty seems to be rising with markets jittery and investment returns low.22Slide23

Current Situation Q4 2016 IIIPolicy uncertainty looms large in EuropeNationalist sentiment on the risePoses a threat to economic policy and long-term investmentBrexit uncertainty will be a drag on the UK and EU.ChinaPolicy makers continue slow pace of reforms to prop up the economyGood news for global growth in the near term.However the government is providing credit stimulus in fits and starts confusing the pictureConcerns now over rising debts and weakening of bank balance sheets

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Current Situation Q4 2016 IVUnited StatesElections for a new president with major implications for domestic, foreign, and energy policyBoth candidates likely to pull back from trade and globalization – sharp break from past policiesDonald Trump’s tax cut proposal would increase federal debt by $4.4 trillion over next decadeFar more stimulus than is required to close current output gap, potentially crowding out private investmentHillary Clinton’s plans would expand the debt by $1.1 trillion over 10 years but with a lift to both tax revenues and spending

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The New Abnormal IThe current situation has been called “The New Abnormal” -It is characterized by:Deficient Demand – hard to generate enough demand to absorb potential global supply – threat of deflationStagnant 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 vulnerableUnstable Politics – political stresses – hostility towards elites, foreigners, international institutions make finding solutions difficultTense Geopolitics – Russia, China, ISIS, Iran, Ukraine – create great uncertaintyChallenge Overload – both domestic and international. Breakdown of global governance when problems mounting – maintain open global economy, climate change, peace.

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The New Abnormal: II

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Slow-Down in Global Trade

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Employment Improving but Stagnant Productivity

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IMF Forecasts, October 2016

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Part IILeading Themes andMajor Risks/Threats30Slide31

Geopolitical/Security Threats Several security trends/threats likely to have an impact on the business operating environment and thus economic securityGrowing anti-establishment sentiment around world -- BrexitChina set to become more, not less assertive over territorial claims in South China Sea following international rulingsThreat of terrorism in Europe from extremist groups and radicalized individuals remains genuineTerror attacks, combined with migrant crisis fueling rise of far-right groups and pull mainstream parties toward populist fringesPolitical and economic crisis in Venezuela expected to worsen with regime change – potentially violent a significant possibilityOil price drop – complicates debt servicing and government budget decisionsAll increase uncertainty and reduce potential investment

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Brexit and Anti-Globalization IU.K decision to leave EU in June 2016 a shock to manyConsequences will be long and profoundAmplified byLack of clarity surrounding itThe mechanism through which it will occurLegislation governing the UK’s future relationship with Europe andThe impact of this new relationship; on the global economyUncertainty will dampen consumer and business sentiment in world’s fifth-largest economyResult – deferred investment decisions and a year of recession in 2017

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Brexit and Anti-Globalization IIFor the Longer term, various assessments predict the UK GDP will be lowerFrom 1.3 to 5.5% per year up to 2020 and 1.2% to 7.5% by 2030Brexit will also exert geopolitical effectU.S. will need to build stronger relations with France and Germany or risk diminished influence in EuropeBoth countries have strong anti-globalization groupsUnlikely that the Transatlantic Trade and Investment Partnership (TTIP), a US-EU trade agreement will be signed.

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Oil Price Decline I

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Oil Price Decline II

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Country Reserves36Slide37

Russian Crisis Russia – Economy in decline for yearsFalling population, brain drain, limited investment, small private sector, over dependence on oil revenues, and very limited reformsCountry hit hard by oil price declineMarch 1, 2016 Russia introduced its crisis plan for the economy Major cutbacks in expenditures Defense and social spending are frequently cited as off-limit areas for cuts so state of economy a major concern.Government anticipating a second year of recession, but smaller than the 3.7% contraction in 2015Still many uncertainties, especially about the level of oil prices

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Russian Crisis II

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African Debt IDebt growing problem in AfricaBorrowing in dollars increasingly risky and expensiveAs local currencies depreciate on softening commodity prices, repayment costs soarThreatening added costs of up to 10.8 billion dollarsMarch 5, 2015 Ghana announced plans for a $1 billion ten year Eurobond to repay part of its debt maturing in 2017Extremely low and increasingly negative bond yields in developed economies encouraging capital flows to AfricaOver past two years African states have issued 22 billion dollars in dollar denominated debtAlmost as much as total sovereign issuance across the region in past nine years

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African Debt II40Slide41

African Debt IIIIn last several months investors becoming more cautiousNow oil exporters would have difficulty issuing debt on favorable termsIn addition to possible slow oil price recovery, principle risk in dollar bond market is threat of earlier than expected U.S. interest rate increaseMarkets could shift very rapidly with borrowing rates increasing sharplyWould make it considerably more difficult for countries to access international capital at affordable ratesOil 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.Question of how much assistance China willing to give.

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OPEC Agreement ISeptember 28, 2016 agreement aims at cutting oil production from roughly 33.24 million  to between 32.5 million bpd and 33 million bpd.Cut marginal, but first since crisis in 2008Also first response since price collapse in second half of 2014 – peak $110, bottomed out at $25 January 2016Issues to be decided before November 30 meeting:Who will shoulder brunt of cuts?How to handle rising production from Iran?How to reconcile differences between producers?

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Largest OPEC Producers

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OPEC Agreement IIOverviewDeal does not necessarily represent attempt to push up pricesInstead, a reaction to market conditions that expect more oil coming online soonWith tentative deal OPEC trying to cushion impact of new supplies – want to prevent prices from dropping below level many OPEC countries are comfortable withOPEC now largely in defensive stance

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OPEC Agreement IIIExplaining the ShiftWithin OPEC Nigeria, Libya, and Iraq seeing small bumps in production and exportsIf sustained could add more than 800,000 bpd over next couple of months – more than entire cut OPEC is proposingThese countries likely exempt from any production cut, although Iraq may be subject to a freezeLibya and Iran have seen their production levels artificially low because of violence and political disputeNigeria militant attacks on pipelines have been repairedIraq deal between Kurdish leaders and government to jointly export 150,000 bpd from Kirkuk

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OPEC Agreement IVBeyond OPECLarge field in Kazakhstan will start coming online in OctoberU.S oil production coming backBetween June 2015 and July 2016 production fell from 9.6m bpd to 8.45m bpd due to low oil pricesProduction stabilizedFuture estimates show a slow rise is prices stay around $50 per barrelIf OPEC tries to maintain a price of $60 would accelerate US production and be self-defeatingOPEC mustMake sure additional production coming on stream does not force price down, while not sending prices up far enough to stimulate shale production

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EM Recovery ILikely a slow painful recovery lies aheadGlobal growth environment remains fragileCommodities will rise only graduallyU.S. monetary conditions are tighteningDebt servicing burdens of EMs are generally high, andEconomic reform is happening at a sluggish pacePositive indicatorsCapital flows into EMs are picking upAssets have rallied since the start of the year (particularly FX) and Valuations are undoubtedly cheap

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EM Recovery IIHard to make the case for a sustained bull market in eitherEquitiesBondsCurrenciesHowever macroeconomic fundamentals will improve at a slow pace and difficult to identify Ems without weaknesses such asLarge fiscal deficitsCurrent account shortfalls andRising debt levelsFor those currencies appreciating the gains will be modest in comparison with heavy losses in recent years

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EM Recovery III49Slide50

EM Recovery IVBright spots – upswing phase of economic cycle with good growth prospects and macroeconomic fundamentalsPhilippines,India,ChileMexico, andIndonesiaAlthough Romania and Poland are accelerating this is being powered with excessively loose fiscal policyCommodity exporters and reform laggards still locked into a slowdown to greater or lesser extentOil exporters are suffering severely depleted government budgets and debt issuance is being ramped up.

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EM Recovery V51Slide52

EM Problems: Lagging Reforms52Slide53

EM Rankings Under Top Challenges

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China: Scenarios IBaseline CaseLeaders prefer growth and stability to reform risking further reliance on debt and leveragingReforms only post 2017 at bestCapital outflows moderateSlow rebalancing away from investment as domestic consumption is strong.Upside CaseBank of China pressured by senior leaders to adopt generalized easing, cutting ratesFiscal expansion means deleveraging further delayed.Banks and SOEs bailed out and forced to operate more commercially

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China: Scenarios IIDownside CaseGovernment fails to stimulate/implement reformsSharp slowdown and possible crisisGrowth slumps, credit boom turns to bustNon-performing loans up to 6-7% of banking assetsMassive outflows, reserve losses, devaluation55Slide56

China: Longer-Term56Slide57

China: Policy ConstraintsWhy can’t China just spend its way out of the slowdown?Optimists point to China’s history of responding to economic challenges – 2008 lending surge, earlier bailout of banking system and a restructuring of state-owned enterprisesProblem China’s debt burden is now much largerSpending now less effective – Private companies have been pulling back on investmentOverall productivity of state spending is lowAlso fear of creating more bubbles in asset markets57Slide58

China’s Risky Portfolio58Slide59

U.S. Budget/Debt Constraints I

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U.S. Budget/Debt Constraints II

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U.S. Budget/Debt Constraints III

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U.S. Budget/Debt Constraints IV

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U.S. Budget/Debt Constraints V

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U.S. Budget/Debt Constraints VI

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Trends in U.S. Defense Expenditures65Slide66

Falling Western Defense Expenditures IAlthough there are a few exceptions there is a stinking contrast between rising defense expenditures in still growing economies and austerity-induced cutbacks elsewhereRobust growth in certain parts of the emerging world, largely Asia, means that these countries can increasingly afford to procure cutting edge defense technologiesIncreased military spending is a zero sum game and will inevitably generate arms racesCertain 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.

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Falling Western Defense Expenditures II

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Falling Western Defense Expenditures V

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Falling Western Defense Expenditures III

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Falling Western Defense Expenditures IV

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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 budgets.

This will require increased cooperation, coordination, and flexibility in adapting to a fundamentally altered budgetary environment

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The EndQuestions?

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