The Global Economic Crisis and Asia: Security Scenarios

1. The Global Economic Crisis and Asia: Security Scenarios FAO Skills Sustainment Pilot Program Naval Postgraduate School June 24, 2010 ROUGH DRAFT Dr. Robert E. Looney relooney@nps.edu

2. Economic Crisis and Security Threats “The global recession is America’s primary near-term security concern.” Admiral Dennis Blair – Director of National Intelligence

3. The Crisis and Increased Threats The greatest threats associated with the crisis include: • The economic and political constraints placed on the U.S. • The economic and political constraints placed on the EU, China, and other potentially stabilizing actors • The crisis of confidence in institutions worldwide, and the threats to the international system • The exacerbation of threats associated with the proliferation of weapons of mass destruction • The consequences of protracted crisis for the world’s weakest states • The threats to weak and weak and weakened states directly impacting U.S. national interests.

4. Key Concerns Brought on By Crisis Main Areas of concern brought on by the economic crisis: • With U.S. economy struggling, emerging powers such as cash rich China and India may extend influence in regions traditionally dominated by U.S. • Latin American/African resources and energy • Technology acquisition around the world • Rising nationalism in may translate into • Expanded protectionism endangering trade • Reduced access for U.S. mineral/oil firms • Less resources available for defense/security expenditures • Expansion of organized crime groups controlling parallel economies • These tend to flourish with rising unemployment • Financing where credit is tight or non-existent • With a prolonged recession – collapse (Pakistan) or severe weakening (Japan) of regimes vital to maintaining international order • Terrorism not the primary security concern elevated by the recession

5. Overview

6. FAO Issues • Things you might want to consider as we proceed: • What elements of the financial crisis are affecting your work as a FAO? • How well do you understand the economic conditions? • Does your understanding or lack of it affect the missions you are doing? • How much of the economic element of national power do you deal with in your work – with the economic crisis as a case in point. • If you could go to a web-site for economic assistance, what types of information do you think would be most useful? • As these or related issues come up in the talk – that would be a good time to discuss them.

7. The World Economic Crisis • The current crisis while severe, shares many characteristics and patterns associated with past crisis • Its origins and underlying causes follow a familiar pattern --- with several unique twists

8. Characteristics of Financial Crisis • All financial crisis share the same core elements: • Some type of shock • Its propagation (how it spreads – contagion) • The broader impact • The Underlying Causes • Primarily microeconomic (e.g. bad banking) • Primarily macroeconomic (e.g. recession) • Primarily institutional (e,g. poor infrastructure or inadequate supervision)

9. Overview of the Current Crisis • The trigger: • Higher than expected defaults on U.S. subprime mortgage loans (bad banking?) • The propagation channel • From real estate markets • to asset-back securities markets • to bank balance sheets • to inter-bank funding markets • to the broader credit markets • to the real economy and • across borders.

10. Causes of the Current Crisis I Over the years the stage being set for the current crisis. Four initial conditions critical. • 1. Assets were created, bought and sold that appeared much less risky than they truly were. • Early 2000s environment stable in most of world with sustained growth and low interest rates. • Investors expected housing prices to continue their rapid increase. • 2. Development of securitization led to complex assets on the balance sheets of financial institutions • Major improvements in risk allocation, • But harder to assess values than the case of simple mortgages • Worries about the original mortgages translated into a large degree of uncertainty about the value of derived securities • The fact that the securities were held by a large set of financial institutions implied that this considerable uncertainty affected a large number of balance sheets in the economy.

11. Causes of the Current Crisis II Initial conditions contd. • 3. Securitization and globalization led to increasing interconnection of financial institutions, both within and across countries. • Foreign claims by banks from the five major advanced economies increased from $6.3 trillion in 2000 to $22 trillion by June 2008 • Claims by these banks on emerging market countries alone exceeded $4 trillion. • 4. Leverage increased within the financial system • Financial institutions increased their portfolios with less and less capital thus increasing the rate of return on that capital. • Optimism and the underestimation of risk key factors. • Numerous regulatory holes • Implications: if for any reason the value of the assets became lower and more uncertain, then the higher the leverage the higher the probability capital would be wiped out and the institutions would become insolvent – exactly what happened.

12. Crisis Timetable The economic crisis has evolved through several stages: • Summer 2007 – initial phase • Subprime mortgage crisis, • Beginning of collapse of stock exchange • Early 2008 – growing stress in advanced countries • Systemic crisis of financial intuitions in US • Economic slowing down in U.S. EU and Japan, but • Overheating inmost emerging markets (high commodity prices, weak US dollar accelerating inflation • Summer 2008 – breaking point • Bursting commodity and other bubbles • Global crisis of financial institutions (bankruptcy of Lehman) • Recession in developed countries • Fall 2008 – crisis hits emerging market economies. • Effects of the crisis world-wide and more severe than in past modern recessions

13. Real GDP Growth, 1980-2009

14. United States: Wealth Destruction

15. U.S. Jobless Recovery

16. Summary: Vulnerabilities and Triggers • U.S. Vulnerabilities • Monetary and fiscal policies too loose to long • Innovation and regulatory failure • Excessive household debt and bank leverage • Global Vulnerabilities • Demand boom and inflationary pressures • Housing and asset price boom • Large and widening imbalances • Triggers • Subprime securities collapse • Lehman failure

17. Four Early Economic/Security Scenarios In late 2008, early 2009 four economic crisis/security scenarios were getting considerable attention – • The Bait Effect – terrorists seeing the U.S. economy melting down calculate that a strike could have a force multiplier because of the already skittish stock market • The China Syndrome – Chinese own more than $500 billion in US. Treasury bonds, and billions more in other U.S. debt. While they would not dump them on the market to disrupt the U.S. economy, they have leverage over U.S. decisions on interest rates, exchange rate decisions. • A Japanese “Lost Decade” – U.S. economy flat in the water for a decade or so – government runs up debt with no stimulating effect on the economy • The Alternative-Dollar Nightmare – countries refuse to hold dollar reserves. Dollar crashes and U.S economy along with it.

18. Factors Contributing to Stability Why didn’t the global system collapse when many in late 2008 were predicting its immediate demise? • Revival did not happen because markets managed to stabilize themselves on their own • Governments learning from the great depression responded quickly through central banks and treasuries • The extensive social safety nets across the industrialized world cushioned the pain • Global system is simply more resilient than we imagined – three major reinforcing elements producing stability • Spread of great power peace – relatively little friction between major nations – rare in history – true global economy • Relatively low rates of inflation – can plan for the future • Technological connectivity – information revolution crated a deeply connected global system – most nations have benefitted greatly from the system – cautious about appeals to nationalism or acts that would jeopardize the current system.

19. Crisis – Direct Implications for the U.S. While the crisis is far from over some patterns with relevance for the U.S. are emerging: • In the short term the crisis has reinforced the U.S. position at the heart of the global financial system. One of the least affected. • The dollar strengthened initially and was viewed as a relatively safe investment • The dollar gains reflected investor sentiment that the U.S. will be the first country to recover from the economic downturn. • Offsetting this, the U.S. has lost some of its prestige in the international community – reducing U.S. Influence • Anglo-American model of capitalism has been discredited – The Chinese model increasingly attractive to many emerging countries. Russian and Chinese leaders have repeatedly criticized U.S. capitalism • Many developing countries are arguing for a larger voice in in International Monetary Fund Fund. Positions in many international organizations taking on an anti-American tone. • As the dollar has begun to decline again, the Chinese have lobbied for an international currency to replace the dollar as the main world reserve currency.

20. Crisis: Potential U.S. Growth The crisis will have a marked impact on U.S. potential growth: • The recession, the rising U.S. debt levels and tighter financial conditions will hurt investment, keeping capital formation well below rates in pre-crisis years • Resulting high and more-persistent-than-usual unemployment will lower potential growth • IMF estimates that U..S. potential output will average about 1.5% over the next five years. • This compares with an estimated 2.0 percent anticipated average in the absence of the crisis • By 2014 the potential output expected to be abut 6 percent below what it would have been in the absence of a crisis • Slower U.S. growth will suppress remittances to and demand for Latin American exports – drag on LAC economies for the next several years

21. Cost of the Crisis

22. World Economy: No Decupling

23. G-20 Crucial Policy: Mitigating Recession • Fiscal Stimulus • Size and burden sharing • Monetary Policy • Quantitative Easing • Bank Restructuring • Asset Purchases • Support to most vulnerable countries (IMF resources) • Preempting Protectionism

24. Crisis Response: Type I Countries

25. Crisis Response: Type II Countries

26. Crisis Response: Type III Countries

27. Crisis Assessment • Despite encouraging signs, still much uncertainty in the world economy • Currently, the global recovery is looking like a V – but that could change quickly • Economic repair is still incomplete and fragilities remain. • Will private sector demand be strong when stimulus over? • Will exit from stimulus policies be well timed and orderly? • Premature retreat can kill the recovery; delayed retreat can raise inflationary likelihood • Medium term growth for the world might be subdued • Fiscal viability of the rich economies in in question • Financial systems in rich countries are still impaired • A slow expansion of world trade is like in the context of rebalancing • Possible adverse impact on developed country investment due to regulatory uncertainty.

28. Overview: Divergent Growth Recovery

29. United States: 2010 Forecast

30. Asia’s Adjustment to the Crisis • Asia

31. Key Transmission Mechanisms to Asia • Trade channel • The region’s exports relative to GDP are among the highest globally • Manufacturing export share in GDP: Singapore (140%), Malaysia (69%), Thailand and Cambodia (46%). • Capital Inflow and FDI • Singapore and Cambodia are major FDI Recipients • FDI to developing countries estimated to have shrunk by more than 30% in 2009 • Remittances • Remittance share of GDP: (Nepal 17%), Philippines (12%), Bangladesh (10%), Sri Lanka (8%) • World Bank estimated a decrease in remittances of 5-8% in 2009

32. Asia: Vulnerability Ranking On Crisis Transmission Linkages II Source: Morris Goldstein and Daniel XIE, US Credit Crisis and Spillover to Asia, Asian Economic Policy Review , 2009

33. Asia: Vulnerability Ranking On Crisis Transmission LinkagesII Source: Morris Goldstein and Daniel XIE, US Credit Crisis and Spillover to Asia,Asian Economic Policy Review , 2009

34. Impact of Fiscal Stimulus on 2009 Real GDP

35. Asia: Patterns of Decline and Recovery

36. China Leads East Asia Out of Crisis

37. Asia’s Recovery Asia’s faster recovery seems to mark a break from the past. • Current episode stands out for several reasons: • This is the first time Asia is leading a global recovery; in all previous global downturns Asia’s contribution to global recover was lower than that of other regions. • Asia’s recovery in previous was generally driven by exports, but this time it has also been reinforced by resilient domestic demand. • While in previous crisis capital had been extremely slow to return to Asia, this time net capital inflows to the region have surged – testament to Asia’s improved resilience and economic framework.

38. Asia: Better Recovery than in 1997-98

39. Asia Bore the Brunt, Now Benefits from the Bounce

40. Emerging Asia: Best Recovery

41. Asian/non-Asian Employment Patterns

42. Asian Contributions to Global Growth (%)

43. Emerging Asia: Unemployment

44. Asia’s Recovery Despite strong growth overall performance of the region was mixed: • Economies with big domestic markets and relatively low export exposure – China, India, Indonesia and the Philippines did not even experience one quarter of year-on-hear contraction. • More externally oriented economies such as Hong Kong, Malaysia, Singapore and Taiwan all contracted in 2009 following a slump in the demand for exports. • Factors that explain better performance in 2009 over last two downturns to hit Asia. • Massively and timely boost provided by monetary and fiscal stimulus. • Region’s fundamentals in much better shaper than 1998 or 2001 • No major asset-price bubbles in danger of bursting • Consumer’s debt levels low • Government’s fiscal positions on the whole healthy, • Region’s banking sector relatively sound with little exposure to US sub-prime debt.

45. Vulnerable Groups At lower end of income scale get a different picture than the macroeconomic aggregates • Youth • Already at least 3 times as likely as adults to be unemployed • Philippines: unemployed youth increased by 5.9% in 2009 • Japan: unemployed youth increased by 23.4% in April 2009 • Compounded by significant labor force growth in some countries (in 2009, 51 million additional jobs needed to absorb Asia’s growing labor force • Migrant workers • Often among the first to be fired (especially newly arrived migrants) • May accept almost any condition just to retain jobs – move to the shadow or underground economy.

46. Cambodia: Hourly Wages

47. China: Off Farm Rural Wages

48. Asia: Low Social Protection

49. Asian Recovery – Optimistic Near Term In the near term Asia is expected to continue to lead the global recovery: • The global and domestic inventory cycle is likely to continue boosting Asia’s industrial exports for most of 2010 as the advanced countries recover • Even with a partial withdrawal of fiscal stimulus, private domestic demand is expected to remain strong as low interest rates continue through 2010 • The pace of the recovery will remain uneven in Asia: • In China growth is expected to return to double-digit s in 2010 with private domestic demand boosted by measures to increase consumption and private demand while beginning to stem the very rapid growth in credit • In Japan, private sector demand faces problem of falling prices and a government facing severe debt constraints. Exports are also facing a strong yen and possible sluggish world markets.

50. Risks to Short-Run Outlook: IMF I • While outlook appears less uncertain than only six months ago, risks remain tilted to the downside: • The main downside risk to the forecasts continues to stem form the fragility of the global recovery • In the near term a risk is that market concerns about sovereign liquidity and solvency in the euro zone periphery might turn into a full blown contagious sovereign debt crisis • While little limited direct impact on Asia the Eurozone problems could result in worsening global risk aversion • Also European banks provide almost half of cross border lending to Asia and further balance sheet deleveraging could affect funding of some key activities in the region. • A further downside risk for parts of Asia comes from commodity prices remaining stronger than currency expected -- contributing to inflationary pressures.