Itaú BBA - Non-traditional risks, By Ilan Goldfajn

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Non-traditional risks, By Ilan Goldfajn

May 6, 2016

Non-traditional risks are unlikely scenarios but would have major repercussions.

While Brazil decides its future, the global recovery moves forward. It may be slow, but the recovery does continue. The process, however, entails certain risks. Some of these are traditional; they warrant attention from the market and are closely monitored. They include the risk of a China crisis and a global recession, or, conversely, the risk that U.S. interest rates will rise faster than expected. There are, though, other risks that are tougher to measure and evaluate. The market has been underestimating them. They are non-traditional risks, like the Brexit, UK’s departure from the European Union (EU), or Donald Trump winning the U.S. elections. They may be unlikely scenarios, but if they did come to pass, they would have major repercussions. We cannot simply ignore them.

Since the 2008 financial crisis, the world has yet to encounter new sources of robust growth. But it has not succumbed to a new global recession, a fear that spread panic through the markets at the start of this year.

But the risk still exists. China remains the biggest global risk and it is capable of triggering a global recession. The challenge it faces is to rebalance its economy, which means refocusing on its domestic economy rather than exports and increasing consumption while reducing excess (and apparently unproductive) investment.

In China. the symptoms currently causing concern are low productivity, excessive debt among state-owned corporations (to banks) and capital outflows. If a crisis does materialize and is accompanied by capital flight, this would lead to a renminbi devaluation and hard landing for Chinese economic activity, causing a global recession and a sharp drop in global commodity prices. The world would suffer, particularly economies that depend on commodity exports.

Luckily, everyone is closely monitoring this risk, not to mention the Chinese authorities that understand the challenges involved. None of this guarantees success, but bad news would be less surprising.

The other closely-monitored risk is the possibility of an abrupt end to a world of zero interest rates and abundant liquidity, that has benefitted emerging economies. The U.S. is the close to raising interest rates this year. The risk is that the Fed find itself behind the curve, forced to raise rates faster than the market expects.

In this case, tighter monetary policy from the Fed would reverse global capital flows, away from emerging economies and into the U.S. This would be tough for EM countries, which have been dealing with a slowdown in economic activity and the difficulties of adjusting to falling commodity prices.

In a way, these are opposite risks. If China does spark a global recession, there will be no inflation and the Fed will not have to hike rates.

Notwithstanding these China and Fed risks, non-traditional risks generate the biggest concern. They are less risks, and more like uncertainties, difficult to measure. Risks are calculated; uncertainties are avoided.

Uncertainty normally leads to paralysis, a situation that has affected investment in Brazil in recent years. However, markets are pushed towards risk taking by record low interest rates and excess liquidity. Therefore, markets end up underestimating risks and ignoring uncertainties, particularly the new, non-traditional ones.

One example of a non-traditional risk is the U.S. presidential election. Donald Trump does not have a very good chance of winning, but if he were elected president of the U.S., many believe this would increase abruptly economic uncertainty. Investors would question the federal government’s fiscal sustainability. According to estimates from the Tax Policy Center (an institution created by the Brookings Institution and the Urban Institute), Trump’s fiscal proposals would increase the federal government debt by USD 11.2 trillion over the next decade. The short-term implication would be a drop in private investment, thereby limiting potential U.S. economic growth in the medium term.

At the moment, the U.S. is growing moderately. Many fear that electing a leader generally perceived as a populist to run the world’s largest economy could trigger a global crisis.

Another example of non-traditional risk is the referendum on the Brexit. The vote is due June 23. A vote for “Brexit” would likely reduce UK potential growth from 2.5% to 1.0%-1.5%. This would also have a direct and indirect impact on the rest of Europe, affecting the region’s capacity for recovery following its recent severe crisis. Stagnation would be likely; recession a possibility.

In this context, if the wave of immigration surges this summer, it would also have political repercussions, bolstering opposition parties that back the European anti-integration movement. Germany’s chancellor, Angela Merkel, has come under pressure because of her pro-immigration policy. Both a UK exit from Europe and immigration flows would undermine the ideal of European integration.

Brazil needs to solve its fiscal and political crisis. This will depend mainly on its own efforts. Global events could be a best friend or a worst enemy. There are several global risks that have warranted market attention – the risk of a global recession or faster rate hikes in the U.S. However, the non-traditional risks, like Brexit or Donald Trump becoming president, demand more attention than they currently receive. Let’s hope they remain for good as risks, not become a reality.


Ilan Goldfajn is chief economist and partner at Itaú Unibanco.


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