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These Three Global Time Bombs Could Go Off at Any Moment

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Thursday, 29 Mar 2012 10:11 AM Current | Bio | Archive

With the first quarter coming to an end, I thought taking a look where three of the major global concerns at the start of the year now stand could be helpful for long-term investors.

We had the eurozone sovereign debt crisis; the political and economical changes in China and the tensions between Israel and Iran.

1. The EU summit of Dec. 9, 2011, that should have definitively set the single currency union on its way to “fiscal union” fell completely short of that goal and unfortunately confirmed the eurozone would remain a “stability union.”

The eurozone is still functioning despite Greece forcing its “private” sovereign bond investors to participate in the biggest sovereign-debt restructuring in history by “orderly” defaulting on its debt to private lenders.

Unfortunately, even with this debt relief, Greece has been forced to impose austerity in its depressed economy. No doubt, Greece is doomed to many more years of suffering. Only time will if that was the right choice to make.

From its side, Spain is facing one of the sharpest economic downturns in the zone with youth unemployment “officially” standing above 50 percent and where the newly elected government already had to admit it could not accomplish its promise of bringing down its budget deficit to 4.4 percent of GDP in 2012. Instead, it had to adjust it upwards to 5.4 percent, hereby overstepping the only just agreed EU fiscal compact that aims to prevent the 17 eurozone states running up too high debts like those which sparked the Greek, Irish and Portuguese bailouts.

Yes, at best we must admit the EU reforms still have a long way to go.

But that’s not all; the key event in the month ahead is without any doubt the French presidential election. In case the socialist candidate Francois Hollande would beat President Nicolas Sarkozy, the eurozone will face another important challenge.

The cause for that is Mr. Hollande, after the Dec. 9 EU accord was reached, said: “This accord is not the right answer ... if I am elected president, I will negotiate, renegotiate this accord, which is all about austerity.”

No doubt, a victory for Mr. Hollande could cause a very significant shift in the balance of power within the eurozone. In Italy, Prime Minister Mario Monti's labor reform plan has caused the approval rating of his “technocrat” government plunging to 44 percent from 62 percent only 3 weeks ago while a very impressive 67 percent of Italians disapproved the reform agreed by the Italian cabinet last week, according to an opinion poll by the ISPO agency, and only 29 percent accepted it. No, that doesn’t bode well… especially in Italy.

In the mean time it has become clear the eurozone debt crisis has its origins in the build-up of excessive financial, fiscal and economic imbalances in the single currency area as well as the global credit cycle. OECD Secretary-General Angel Gurría said the eurozone needs to boost the firepower of the European stability funds to over one trillion euros ($1.328 trillion) while the current level of commitment to the two EU rescue funds, the temporary European Financial Stability Facility (EFSF) and the permanent European Stability Mechanism (ESM) when used in parallel is about 700 million euros ($929 million), which is obviously not enough to restore market confidence.

“Europe is stalling. It needs to get out of first gear and make growth the number one priority,” Mr. Gurría said.

Achieving prudent debt-to-GDP ratios that are now too high in most eurozone countries will take many years of tight fiscal policy. No doubt this would be facilitated by stronger growth, which is clearly lacking for the moment.

The latest Markit Flash eurozone PMI suggests that the eurozone has slipped back into a technical recession. Only Germany and France seem to have avoided a relapse. Elsewhere in the eurozone both business activity and employment have fallen sharply again in March.

Confidence in euro area sovereign debt is bound to remain fragile for quite some time to come. The crisis still needs to be resolved by restoring confidence and dealing with the underlying causes, which will be extremely difficult to achieve in contracting/extremely slow growth economies. No, the EU crisis hasn’t run its course.

2. For China, 2012 is already shaping up to be one of the most significant years in at least half a decade. In late January, a three-step plan for loosening the government’s capital and FX controls over the next five to 10 years was announced. Investors should pay attention that free convertibility of the renminbi/yuan (CNY) would be “the last step” to be taken at some “unspecified” time with restrictions on “speculative” capital flows and short-term foreign borrowing.

In this context, Premier Wen Jiabao indicated two weeks ago that a band widening for the renminbi/yuan is likely this year.

On March 5, Premier Wen announced in his speech to the National People's Congress that the government was to target 7.5 percent y/y economic growth this year and thereafter 7 percent in the current five-year plan, hereby dropping the 8 percent goal that has been in place since 2005. The Chinese model should also shift to “higher quality of development over a longer period of time.” Believe me, this is extremely important to China, but also to the world economy.

The major challenge for China will be that it will need “difficult” political reforms in order to support such a major shift in its growth model and that will unavoidably adversely affect vested interests, particularly in local government and state-owned enterprises at a moment we have the once-in-a-decade political transition at the head of the Chinese communist party.

The needed reforms have been well laid out in a joined report of the World Bank/China’s Development Research Center of the State Council.

I have no doubt we’ll see political struggle at the highest level and behind the usual curtains. The political situation in Beijing should be on investors’ radar watch in the months ahead, especially at a moment that China faces slower growth numbers and when serious concerns about the property market remain a nightmare.

An important side effect of all this would probably be a (much) slower growth of China’s FX reserves while we are at the offing of major policy changes.

Investors should not overlook the fact that China’s reserves have risen since 2002 from $227 billion to $3.18 trillion this year while China has reduced its dollar reserve holdings to about 54 percent partly in favor of the euro, which explains in part the continuing, until now at least, strength of the euro notwithstanding the continuing eurozone debt crisis. No, that situation will not continue and China will not be the global growth engine we have known it to be in the past.

3. On the Iran related threat to the global economy, it could be helpful to remember that just as recently as last month, U.S. Defense Secretary Leon Panetta said he believed there was a “strong likelihood” that Israel would strike Iran in April, May or June. Besides, there is also, among the Israeli public, a growing sense that a confrontation with Iran is inevitable. In January, the Center for Strategic and Budgetary Assessments (CSBA) published an enlightening report, wherein it states: “… Iran is (also) pursuing capabilities that would allow it to deter, delay, or prevent timely U.S. operations in the Persian Gulf.”

Keep in mind on June 29, 2008, commander of the Revolutionary Guard, Ali Mohammed Jafari, stated “explicitly” that if Iran were attacked by Israel or the U.S. Tehran would seal off the Strait of Hormuz. In response, the commander of the US 5th Fleet warned that such an action would be considered an “act of war.”

Now, so far, Israel’s Prime Minister Benjamin Netanyahu has shown no sign at all that a pre-emptive strike against Iranian nuclear facilities has been abandoned.

The logical question is how Iran would react were Israel to strike about six or eight Iranian facilities it has on its list. Notwithstanding there is practically no chance Iran would formally declare war, we must admit it’s also fully in the cards Iran would try, among other things, to close the Strait of Hormuz, which would without any doubt push oil prices firmly higher. How much higher oil prices could go will remain anybody’s guess until we’ll have to face it (hopefully not?)

Of course, a lot would depend on the “effectiveness” of Iran’s retaliations (yes, in plural), notwithstanding additional supplies from Saudi Arabia and calls to dip into Western strategic reserves.

Bottom line: There are no signs that these three very important risks we faced at the start of the year have abated.

The eurozone remains in its “dark” forest. China is bound for slower growth and “inside” political struggle. The situation with Iran could derail at any time, notwithstanding for now, if it happens, it will be after the meeting that starts on April 13 between Iran and six world powers — the United States, Britain, France, Germany, Russia and China — for new round of talks on Iran’s nuclear program.

President Barack Obama has said there is still time to resolve the dispute over Iran diplomatically, but that the window is closing.

All these risks don’t allow, at least in my opinion, investors to become complacent. Investors should remain very cautious.

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2012-11-29
Thursday, 29 Mar 2012 10:11 AM
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