In business and economics, the biggest threat is the one that we cannot forecast. This is why it is important to identify the wild cards that could play out differently from what the majority are expecting.
The consensus view is that the credit crunch and the weakening US housing market will slow world economic growth to 3.5 per cent in 2008 from 4.9 per cent in 2007, with the US growing at 0.5 per cent, down from 2.2 per cent in 2007. This will put downward pressure on oil prices, bringing them closer to the $70-level, down from the highs of $100 a barrel in late 2007. Expansionary fiscal policies in various Arab countries and lower domestic interest rates, moving in tandem with dollar rates, will help maintain the tempo of strong economic growth in the region, and fuel inflationary pressures leading to higher real asset prices. Commodity prices will remain high even in the face of a US economic slowdown, underpinned by generally weak dollar.
Here are some of the surprises or wild cards that could form credible threats to the consensus view. Their importance derives from the fact that they are inter-related. A surprise in one area could trigger events and generate surprises elsewhere, leaving their impact on the regional and global scene.
1. Deeper recession in the US
The first wild card is a deeper recession in the US than markets are expecting. The burst of the housing and credit bubbles could spill over into consumer spending and credit card finance, reducing growth further and dragging the US into a deeper recession. Canada, Mexico, China and others whose exports to the US range between 15 per cent and 20 per cent of their respective GDP, would be the hardest hit. Slower world economic growth would impact global demand for oil and would bring sharper decline in oil prices, down to the $50 a barrel. Lower oil revenues and the reversal of the feel-good effect would leave their impact on economic growth and corporate profitability. This could bring forth lower asset prices [stocks and real estate] and deflate household wealth.
2. Rising inflationary pressures
The second wild card is rising inflationary pressures in the region that governments are finding difficult to control, rendering inflation more of a structural rather than a cyclical phenomenon. This could lead to the drop in purchasing power, negative real interest rates, rising income inequality and social dissatisfaction, higher wages feeding into higher inflation, loss of competitiveness and the risk of a hard landing later on. Domestic demand is being fuelled by strong government expenditures aimed at upgrading infrastructure, and excessive growth in domestic liquidity. There are overheating pressures on the supply side as well, with rising rents due to tight housing and property markets and higher costs of food and imported material. Because countries of the region have their currencies pegged to the dollar, they cannot implement the much-needed counter-cyclical monetary polices. What is required is a more disciplined fiscal policy where government expenditures will grow in a measured way, complemented with raising minimum reserve requirements and the regular issuance of government bonds, CDs and sukuks to absorb excess liquidity and sterilise its impact on real asset prices.
3. Financial shock
The other wild card is the threat of a financial shock that may originate from the massive financial surpluses accumulated by China and the main oil producing countries. In 2007 Opec’s current account surpluses are estimated to have exceeded $300 billion (Dh1.1 trillion), higher than the combined surpluses of Asia’s developing countries, including India and China. In the meantime, the US owes $3trn to overseas creditors, making it much more vulnerable to foreign financial manipulation. If the outcry against sovereign wealth funds intensifies, with politically motivated restrictions imposed on the investment of these funds, this could greatly disrupt the free flow of capital and lead to a protectionist back lash. Certain sovereign wealth funds may be forced to go on the defensive and take unexpected measures aimed at protecting their own economic interests. This would create a spark for a broader investor stampede, adding to financial turmoil and instability.
4. Decline in realty prices
A fourth wild card is the decline in real estate prices in our region, under the weight of excess supply, tighter lending conditions and the general trend of weaker property prices worldwide. The perception that real estate prices here and abroad have peaked may encourage speculators to sell the property they hold before prices start to actually decline in their domestic markets. The additional supply coming to the market will be seen in the form of building of inventory, less sales and eventually lower prices. The decline in real estate prices would reduce household wealth, bring forth lower consumption and economic growth and possibly damage the asset quality of banks. Its impact will vary from one city to another, being more visible in those countries where real estate prices have surged most in the past few years.
5. Slide in commodity prices
Another wild card is the possible slide in commodity prices this year. Slower growth in world demand for commodities and a stronger US dollar would make such an event a possibility. China and India, who were responsible for 70 per cent of the increased global demand for metals and commodities last year cannot keep on growing at annual rates of 10 per cent or more if the US and Europe slow down. In the cyclical world we are living in, the stunning rise in commodity price index of 100 per cent since the recession of 2001, suggests that commodity prices may have peaked as the world economy assumes a declining growth path. This scenario becomes more likely if the US dollar, in which commodities are denominated, stabilises and then strengthens in the months ahead.
Central banks that proactively cut interest rates to bolster growth may well see their currencies rally. Hedge funds seeking alternative investments in commodity markets rose from $3bn in 2001 to about $120bn last year. If increasingly more funds reverse the long positions they are holding and sell commodity contracts in the forward market, this could expedite the decline in commodity prices and could have positive repercussions on inflation worldwide and also in the Middle East region.
To conclude, the region is experiencing a period of growth and prosperity that is likely to prevail in 2008. Even when conditions are good, and there has rarely been a better time to do business in the region, one should not be complacent. Instead, we should try to heed the lessons of previous years, ie to expect the unexpected.
(The writer is the CEO – Middle East and North Africa, Deutsche Bank)
Five wild cards that could change the game