The two big political events of 2016 – the Brexit referendum on June 23 and Donald Trump’s victory in the US presidential election on November 8 – have added significant uncertainty to an already fragile global economy. Due to economic and political uncertainty caused by the Brexit vote, the IMF has lowered the global economic growth forecast for 2017 to 3.4%.
Eight years after the onset of the global financial crisis in 2008, the economic recovery remains uneven in most advanced economies with persistently weak private demand and limited job growth. The financial crisis is far from over, only its intensity and geography have changed. The crisis led to a severe global economic recession followed by sovereign debt crises that are ongoing in the Eurozone.
In terms of macroeconomic parameters (growth, employment, inflation, trade), one finds major weaknesses in one region or another. Some analysts view unemployment rate dropping to 4.6% (the lowest since 2007) in November 2016 as a sign of a stronger recovery in the US. However, most of the new jobs created in the US were in low-wage sectors such as bars and restaurants. According to the US Bureau of Labor Statistics, out of the 178,000 new jobs added in November 2016, only 9,000 are full time jobs while part-time jobs increased by 118,000. Hence, the quality of jobs is a major concern as good jobs are being replaced by bad ones.
The world economy will face multiple challenges in 2017, largely due to political factors. There was a time when the political risk was largely seen in the context of poor and developing world (for instance, military coups taking place in Pakistan, Nigeria or Burundi). But now political risks and uncertainty are building up in the developed countries, particularly those in the EU.
The “Brump” factor
The Brexit vote was the biggest shock to the political establishment in the UK and across Europe. Six months since the vote, there is still uncertainty over whether Brexit will actually occur. British Prime Minister Theresa May has insisted that her government is “getting on with Brexit” even though the high court ruled that the UK could not leave the EU without parliamentary approval.
Now the legal battle over the Brexit process has moved to the Supreme Court as the government has challenged the high court ruling. If the UK government wins its case in Supreme Court, it can invoke Article 50 of the Lisbon Treaty – the legal process to exit the EU – in March 2017. The exit process is expected to take a minimum of two years.
While it is in the UK’s interest to seek an orderly exit, the government has so far refused to divulge its Brexit strategy, saying that to do so would weaken its prospects of negotiating a favourable deal with the EU. Some analysts believe that the UK will gain more leverage by delaying the negotiations with Brussels. May is keen to have a bespoke arrangement but there is no guarantee that all the 27 member-states of the EU may approve such an arrangement.
The sterling has fallen by 14% against the dollar since the Brexit vote. As the city of London is the leading international financial centre, ongoing uncertainties related to the timing and nature of the Brexit process could pose additional risks to the global financial system.
In the US, Trump’s victory in the presidential election was another major political upheaval. President-elect Trump has already announced that he would dilute or dismantle regulatory measures undertaken to implement Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. A deregulation push under his presidency could free US big banks from new regulatory rules introduced in the aftermath of 2008 crisis. In other words, the big US banks may become even bigger if the already tepid Dodd-Frank Act is dismantled.
His other policy agenda on international trade, climate change and immigration issues will be closely watched as most of his cabinet colleagues are business elites with hardly any public office experience.
Needless to say, people around the world anxiously wait to see how the “Brump” phenomenon (Brexit plus Trump) unfolds in the coming months.
The rise of far-right in Europe
Almost every European country has witnessed a surge in support for far-right political parties in recent years. Such parties have been able to garner substantial popular support based on their anti-immigration policies and nationalistic outlook.
In 2017, elections are due in the Netherlands, Germany, France and possibly Italy. Most political analysts expect far-right parties to achieve big electoral gains on an anti-establishment sentiment fuelled by the Brexit vote and Trump’s victory. The possibilities of such parties coming to power are far greater now than ever.
Instead of targeting austerity programs and neo-liberal economic policies contributing to economic instability and unemployment, far-right political parties use nationalist, anti-immigrant and xenophobic rhetoric to woo public support.
The growing popularity of far-right political parties across Europe indicates there are possibility of other countries leaving the EU, including France (‘Frexit’), the Netherlands (‘Nexit’), Italy (‘Italeave’) and Austria (‘Auxit’). In all likelihood, the EU may survive Brexit but a Frexit would completely jeopardise the entire European integration project.
The global banking system fragility
The global banking system is still in a fragile state. The big banks, particularly in crisis-hit countries, are facing numerous challenges despite huge efforts being made by central banks and governments to clean up their balance sheet. According to the Global Financial Stability Report (October 2016) of the IMF, over 25% of all banks in developed countries (controlling $11 trillion in assets) remain weak.
In the US, very little progress has been made to prevent taxpayers from bailing out “too-big-to-fail” banks. The resolution authority has not ended the problem of banks being too big to fail. Under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, banks are required to create “living wills” outlining how they would shut down their business if they fail, at no cost to taxpayers. In April 2016, the US regulators issued a failing grade to five big banks (including Bank of America, Wells Fargo and JPMorgan Chase) on their emergency wind-down plans in a crisis-like situation. Put simply, if another financial crisis hit the US today, these banks would need a bailout from the US government to prevent a major financial crisis from happening again.
In Europe, high levels of non-performing loans may spark new crises in the banking sector in the coming months. According to KPMG, the European banking sector has about €1.1 trillion in non-performing loans and an average NPL-ratio of 5.7% (three times as much compared to the US or Japan). The policymakers are currently focusing on eight of Italy’s troubled banks. In particular, the financial position of Italy’s Banca Monte dei Paschi di Siena, the oldest surviving bank in the world, is extremely weak as it was the worst performer in the annual stress tests carried out on 51 lenders across the EU in late-2016. The bank has nearly €50bn in non-performing loans, accounting for 38% of its total loans. It recently failed to raise €5bn in fresh capital as part of its recapitalisation plan. Hence, a state bailout of this ailing bank cannot be ruled out even though such a move may not comply with EU state aid rules.
Deutsche Bank is in trouble
The weak financial strength of Deutsche Bank should be a matter of grave concern. Since 2008, Deutsche Bank has faced numerous lawsuits and investigations over its alleged role in rigging of interest-rate benchmarks and commodity prices, violations of US sanctions and mis-selling of mortgage-backed securities. Even after paying more than $16 bn in fines and settlements worldwide since 2008 for serious misconduct, the troubles at Deutsche Bank are not yet over as it has lost more than half of its value in 2016.
With Deutsche Bank having a leverage of 40 times, some analysts forecast that the impending failure of Deutsche Bank may trigger a far bigger financial crisis than the 2008 crisis. As Deutsche Bank is highly interconnected with other big banks and insurance companies in Germany, there is a valid concern that it could pose a systemic threat to Germany’s entire financial sector.
In June 2016, the IMF in its report on Financial System Stability Assessment on Germany stated that “among the G-SIBs ((globally systemically important banks), Deutsche Bank appears to be the most important net contributor to systemic risks, followed by HSBC and Credit Suisse.” The report further noted that “Germany, France, the UK and the US have the highest degree of outward spillovers as measured by the average percentage of capital loss of other banking systems due to banking sector shock in the source country.”
Further, Deutsche Bank is the biggest European bank in London with a staff strength of 8,000. The bank generates nearly 20% of its revenue from the UK and therefore is exposed to greater Brexit risk than other European banks.
In the UK, the Royal Bank of Scotland (RBS) failed in the annual stress test carried out recently by Bank of England. The UK government had bailed out the RBS in the aftermath of 2008 crisis. The RBS is currently 73% owned by the UK government. It is important to emphasise here that any further weakening of financial strength of RBS will directly impact the UK’s public finances because of 73% public ownership of this bank. Similar will be the fate of many other European banks which were bailed out by their national governments following the 2008 financial crisis.
What about bright spots?
In 2016, India and China were seen by many as the two bright spots on the world economy map but both economies are facing their own challenges.
Post-demonetisation, India’s GDP growth projections have slipped. Launched on November 8, the stated objective of the demonetisation initiative was to crack down on the black (shadow) economy. At the time of writing, news reports point out that this policy objective has not materialised as 94% of demonetised notes have been deposited back in the banks, thereby putting a big question mark on the efficacy of this entire initiative which put mass hardship on the majority of India’s 1.2 billion people.
There is a growing evidence to show that the demonetisation initiative has badly affected the informal sector (which constitutes roughly half of India’s economy) where legitimate cash transactions are common. In the rural and semi-urban areas where banking infrastructure is sorely lacking, this move has negatively impacted the jobs and livelihoods of working people who earn and spend money in cash. Numerous media reports have highlighted how cash shortage has led to the closure of many micro and small enterprises throughout the country, with adverse impact on incomes and jobs of people associated with these enterprises. In particular, agriculture, textiles, jewellery, retail trade, automobiles, real estate and construction sectors have been adversely hit by the demonetisation initiative. In such a scenario, an immediate revival of economic activity is unlikely to happen.
In the case of China, the shadow banking system (non-bank financial intermediaries) poses a potential systemic risk given its large size and opaque nature. Since shadow banking institutions are interconnected with China’s commercial banks, risks in the shadow institutions can easily be transmitted to the Chinese banking system.
Brazil and Russia suffered heavily to due to crash in commodity prices in the past two years. Now as commodity prices have stabilised, it is expected that both these economies may come out of recession in 2017.
To sum up, the world economy is not out of the woods yet. A more robust, sustained and balanced global recovery is still missing.
The global financial reforms implemented so far are inadequate to prevent another crisis from happening. The political will to implement global financial reforms is currently missing at G20 – the premier forum for international economic cooperation. At G20, the progress in regulatory cooperation has been patchy and spasmodic. The member-countries of G20 have yet to implement several past commitments on financial reforms. With the result, the policy agenda to create a more transparent, inclusive and resilient global financial system has lost momentum. At the opening session of the G20 Hangzhou Summit, Chinese President Xi Jinping urged the G20 to be a “group of action, instead of a talk shop.” It appears that G20 leaders have forgotten about the root causes of the global financial crisis.
Kavaljit Singh works with Madhyam, New Delhi, where this piece originally appeared.