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CONTINENTAL DRIFT
AN ANALYSIS OF GLOBAL POLITICAL RISK
DECEMBER 2012
2
Political risk is something typically associated with poor, unstable nations. Those countries, usually hot
ones, where the deals get done in hotel lobbies by men with firm handshakes and an armoured four
wheel drive. But this view is mistaken; the impacts of government decision makers pervade commercial
life in developed countries too. Nowhere has this been more readily demonstrated than by the mature
democracies of the North Atlantic as they flounder in the aftermath of the financial crisis.
This report takes as its central tenet the idea that, wherever you are deploying capital, there is no room for
complacency about political risk. Our teams in London, Brussels, Washington and Singapore have picked
the key developments that they think could shape the political economy of their regions in 2013. Areas
where we do not have regional offices, namely the Middle East and Latin America, have not been covered.
In addition, we have interviewed a range of commentators and market participants to get their views on
the year ahead. You will see their analysis in the Viewpoint boxes throughout the report. The result is a
rich smorgasbord of fact, opinion and crystal ball gazing.
This is not an enterprise with scientific pretensions nor is it exhaustive. Rather, the main purpose of this
analysis is to provoke discussion and debate about the year ahead.
John Rowland
Senior Country Officer
Cicero Group
INTRODUCTION
3
CONTINENTAL DRIFT
Many of the risks in the year ahead could be
the result of what might be characterised as
drift. This applies in two senses: First, a lack of
leadership and political will that leaves nations
and regions without a clear strategy to solve
serious long-term challenges. And second, in
the sense of drifting apart through a divergence
of interests over time.
In the United States all eyes are on the fiscal cliff
kabuki. It looks like a deal is in the offing that could
see Republicans u-turn and accept tax rises. For
all of the fuss, the fiscal cliff negotiation is merely
Washington digging out of a hole it created for
itself. But the long-term challenges of reforming
entitlements and tax codes will not be settled
by the cliff and are much more complex. Will
President Obama and Speaker Boehner turn their
attentions to this in the New Year? Or will the deal
leave the prospects of a long-term deal in tatters?
A lack of action here will leave the US drifting
towards a genuine fiscal crisis.
The United Kingdom is drifting apart from the
EU. As the eurozone prepares to chart a more
integrationist course, a referendum could ask the
British people for their views on future relations
with the EU. But is there a credible strategy for
life outside of the EU? Or will the UK stay inside
as a semi-detached member? Without a well
formed plan, British business will suffer from the
uncertainty.
Without imminent calamity in the European Union
to focus minds on reform, and with forthcoming
elections in Italy and Germany, could we see
leaders put essential structural changes to the
Economic and Monetary Union on the backburner?
Is it possible that, ironically, the relative calm in
markets leaves the bloc drifting towards another
crisis? We also picked out the EU drifting towards
protectionism as a risk – though we could easily
have argued the same about the US in its attempts
to apply financial regulation extra-territorially. We
will come back to the issue in a future report.
Cicero contributors
Editor: John Rowland
UK: Daniel Wright, Cameron Rae, Georgina Rawkins
EU: Saana Kyröläinen, Tim Gieles
US: John Rowland, Peter Benton Sullivan
Asia: Andrew Naylor
Panel of experts: for a full list of all external
contributors, please see appendix (p45)
Each of the experts gave their opinions. Their
participation does not infer endorsement or
agreement with any other content in the report
Finally, could the slow escalation of a regional stand-
off over shipping lanes and resources in the Asia
Pacific region cause countries around the South
and East China Sea to drift into open conflict? In a
region that has driven the global economy, such a
confrontation is a very worrying prospect.
These are just some of the things that we think could
shape 2013. We hope you enjoy reading it.
4
CONTENTS
POLITICAL TIMELINE	 5
ABOUT CICERO	 46
2013
UNITED STATES OF AMERICA	 6
THE FEDERAL BUDGET: STUCK BETWEEN A CLIFF AND A HARD PLACE
STATE BUDGETS: UNITED IN PAIN
STUDENT LOANS: NOT MAKING THE GRADE
SHALE ENERGY: AMERICA’S GET OUT OF JAIL FREE CARD
ON THE AGENDA – THINGS THAT WILL DRIVE THE DISCUSSION IN 2013
UNITED KINGDOM	 15
THE COALITION: CAN THEY GO THE DISTANCE?
THE CUTS: AT WHAT COST?
UK AND THE EU: DRIFTING APART?
ON THE AGENDA – THINGS THAT WILL DRIVE THE DISCUSSION IN 2013
EUROPEAN UNION	 24
EUROZONE: WHEN THE FIRE IS OUT, WILL LEADERS SEE THROUGH THE SMOKE?
NATIONAL ELECTIONS THAT COULD CHANGE THE COURSE OF THE EUROZONE
A PROTECTIONIST SHIFT
ON THE AGENDA – THINGS THAT WILL DRIVE THE DISCUSSION IN 2013
ASIA PACIFIC	 33
MARITIME DISPUTES: MAKING WAVES IN ASIA
AN ASEAN-CENTRIC ASIA?
CHINA’S LEADERSHIP: A NEW GENERATION TO SHAPE THE NEXT DECADE
ON THE AGENDA – THINGS THAT WILL DRIVE THE DISCUSSION IN 2013
JANUARY
Israel
General
election
23-27 JANUARY
World Economic
Forum Annual
Meeting
Davos,
Switzerland
FEBRUARY (tbc)
Italy
General
election
2013
2014
JanuaryFebruary
March
April
AugustSeptember
May
July
November December
June
MARCH (tbc)
China National
Peoples’ Congress
and People’s Po-
litical Consultative
Conference
Beijing
2-5 MAY
ASEAN+3 Finance
Ministers and
Central Bank
Governors Meeting
New Delhi
19-20 APRIL
Spring meetings
of the World Bank
and International
Monetary Fund
Washington DC
To be held by:
1 NOVEMBER
Australia
General
election
13-14 JUNE
G8 Summit
UK
SEPTEMBER
G20 leaders’
Summit
St Petersburg,
Russia
SEPTEMBER
Austria
General
election
OCTOBER
APEC Leaders
Summit
Bali, Indonesia
OCTOBER
Annual meetings
of the World Bank
and International
Monetary Fund
Washington D.C.
General election
Key events
POLITICAL TIMELINE
October
1 SEPTEMBER -
27 OCTOBER
Germany
General
election
NOVEMBER (tbc)
ASEAN Heads of
Government
Meeting and East
Asia Summit
Brunei
2-5 MAY
Asian
Development Bank
Annual Meeting
New Delhi
30 MARCH
The 5th BRICS
Summit
South Africa
5-7 JUNE
World Economic
Forum on East
Asia
Myanmar
27 JUNE
Malaysia
General election
JUNE
Iran
General election
6
UNITED STATES OF AMERICA
THE FEDERAL BUDGET:
STUCK BETWEEN A CLIFF AND A HARD PLACE
The issue:
After fiscal cliff negotiation is concluded, America’s leaders fail to chart credible path to long-term
fiscal sustainability
As this report went to press, bipartisan negotiations were underway to avert what has become known as
the ‘fiscal cliff’, a mix of automatic tax rises and spending cuts due to hit simultaneously on Jan 1 2013.
US experts interviewed by Cicero Group for this report agreed that the aftermath of the fiscal cliff was the
most important political risk in 2013.
Going over the cliff would take care of the deficit in short order. But the economic shock would cause a
recession in early 2013. The alternative, doing a deal to avert the cliff, would prevent the ignominy of a
recession with ‘Made in Washington’ stamped all over it. But it would also leave the US drifting towards a
debt crisis. (See box 1).
However, the fiscal cliff will not address the key long-term challenges facing the US, namely reform of
entitlements and the tax code. This will require much tougher choices to be made about the size and role
of government than those presented by the fiscal cliff negotiations. The danger is that the fallout of the
fiscal cliff poisons the chances of reaching a credible deal, strangling future economic growth and scaring
debt markets in the longer term. Alternatively, the deal may allow politicians the breathing space to turn
attentions to other matters and punt on the reforms needed to guarantee the long-term fiscal health of the
country.
Viewpoint:
Senior Wall Street government relations professional
I’m optimistic that Congress and the President will achieve an agreement on the fiscal cliff by year
end. That said, I think the chances of a meaningful long-term deal on entitlements and revenues are
less than 50 per cent. Sure, there will be some revenue increases and spending cuts, but the election
didn’t suspend the laws of political gravity and it won’t take long for the intense partisanship to
dominate the discussions such that a meaningful deal will be difficult to achieve.
USA
7
Estimated ownership of US Treasury Securities as of March 2012
Source: US Treasury
The US government is its own biggest single creditor, largely due to the holdings of the Social
Security Trust Fund. However, most debt is held by the public. The largest class of public
investor is foreigners (including overseas governments) with more than $5tn in holdings. Public
investors perceive treasuries as safe assets issued by a creditworthy government. However,
rating agencies and bond markets will become nervous if sustainable fiscal reform is not
forthcoming.
Box 2 Uncle Sam’s creditors
US Savings Bonds, 185
Depositary Institutions and Insurance Companies, 561
State and local governments inc. pension funds, 625
Other investors, 1230
Mutual funds and private pension funds, 1450
Foreign and international investors, 5135
Federal Reserve and Intergovernmental holdings, 6397
0% 25% 50% 75% 100%
As a result of previous failures to come to a bipartisan
budget agreement, current law would see $500bn in
defence cuts and more than $2.7tn in tax increases
over ten years from Jan 1 2013. This fiscal sledge
hammer would put debt on a downward slope, but at
the cost of serious economic dislocation.
On the other hand, ‘Realistic Baseline’ projections
by the Committee for a Responsible Federal Budget
suggest that a deal to avert the fiscal cliff – which
might see taxes go up on the rich and much smaller
spending cuts – would nevertheless lead to huge
increases in debt in the longer term.
It is worth noting that these percentages do not
include debt held by the government. As such the ratio
of gross debt to GDP is considerably higher than these
charts suggest. The OMB estimates a gross debt ratio
of 105 per cent by the end of 2012.
Box 1 Fiscal cliff vs deal – the implications for US national debt
2000 2010 2020 2030 2040 2050
0
50
100
150
200
Debt projections (debt held by public
as percentage of GDP)
Source: Committee for a Responsible
Federal Budget
CFRB
‘Realistic
Baseline’
CBO Current Law
Per cent
Year
USD,billions
8
USA
What happens next:
What happens next: beyond the ‘fiscal cliff’ – drift or action?
Neither outcome to the fiscal cliff negotiation is optimal. But the experts we asked agreed that the best outcome
is a short-term deal now, followed by a serious effort to achieve a long-term bipartisan deal in 2013. The first
part looks likely to happen. The second part will be much harder to reach agreement on.
What would a long-term deal have to address? First, a way to arrest the annual growth rate of the costs of
Medicare and Medicaid, currently at 6.3 per cent and 8.1 per cent respectively. Secondly, an overhaul of the
labyrinthine tax code, ideally including modernisation of the uncompetitive corporate tax system. Dusting off the
Simpson-Bowles proposals may not be a bad place to start.
The risk is that the opportunity to set out a new path in 2013 is squandered. If that comes to pass, the
implications will be far-reaching. Where will the money be found to fund the renewal of America’s creaking
infrastructure? Will America be able to preserve its military pre-eminence? And what of the public school system,
which underperforms woefully for a country of America’s wealth?
The pressure is therefore on President Obama and Congress to think long-term in 2013. If they do, it would
send a signal to the public, business and creditors that America’s leaders are more interested in governing than
partisan manoeuvring. But endlessly kicking the can down the road will saddle the country with debt, erode its
competitiveness and eat away at the credibility of the US system of government.
How we got here:
Partisan rancour brings US to cliff-edge
The US Treasury has financed two major wars and a huge bailout package over the last decade.
Spending on entitlements, such as the popular Medicare programme, is increasing as the population
ages. Meanwhile, on the revenue side, costly temporary tax cuts introduced by George W Bush have
been extended. Growth continues to be weak, depressing tax receipts. A complicated tax code full of
allowances, deductions and loopholes is economically inefficient and costly to administer. Democrats and
Republicans agree that the situation is not sustainable, but they have not been able to agree on what to do
about it.
Attempts to come to a comprehensive, bipartisan
deal, such as the 2010 Simpson-Bowles
Commission, ended without agreement. This
is because Republicans have refused any deal
that involves tax increases, wanting instead to
see sharp cuts in spending and further tax cuts.
Democrats on the other hand have insisted on
increased taxes – particularly on the rich – and
smaller cuts to spending. As a secondary matter,
the White House is now also asking for powers
to raise the debt ceiling without recourse to a
Congressional vote, which the GOP opposes.
Whether the gap can be bridged is at the heart
of the fiscal cliff negotiations and thus, indirectly,
whether a long-term budget deal can be reached
at a later date.
“Medicare and other healthcare spending
will nearly double in the next 35 years as
a share of the economy, approaching the
amount we currently spend on everything
else outside of Social Security. Taxes as a
share of the economy will have to rise to a
level never before seen in the US in order
to pay for that increased spending”
Scott Winship, Brookings Institution
USA
9
Viewpoint:
Ike Brannon, Director of Economic Policy,
American Action Forum
The resolution of the fiscal cliff will determine
whether Congress and the Administration can
work together to complete a fundamental reform
of the tax code and the entitlement problem in
2013. The President has the ability to press the
Republicans into taking a tax rate increase and
could walk away from that declaring victory. But
such a victory would be a hollow one at best.
Making Republicans walk the political plank
would poison future negotiations between the two
parties, making tax reform – or any other major
bipartisan legislation – nearly impossible.
If the President wants a second-term legacy,
addressing the corrupt, antiquated tax code and
entitlement system would be a good start. If it’s
done by a President Hillary Clinton or a President
Chris Christie, the punt will be a blot on Obama’s
legacy.
If he manages to create a constructive working
relationship with Republicans during his last
four years in office, that alone would be an
accomplishment. Here’s betting that he gives
the Republicans a chance to save face and keep
them from having to vote for higher tax rates.
Viewpoint:
Jason Peuquet, Research Director,
Committee for a Responsible Federal
Budget
At this point, it is clear that doing nothing to
control deficit and debt down the road is simply
not an option. The fiscal cliff is an opportunity to
put in place the beginnings of a smart and gradual
deficit reduction package. We’re hopeful that
elected leaders can set the stage for entitlement
reforms and tax reforms to be worked out
early next year to ultimately put the debt on a
downward path as a share of the economy.
Viewpoint:
Senior Wall Street government relations
professional
I think the US political system is close to a crisis
point. In my several decades in Washington, I’ve
never seen the interests of the public and the
parties so divergent: while today the American
public – not to mention American business –
fervently want the parties to work together to
address problems, the parties meanwhile are
focused on satisfying their bases. Either some
exogenous force occurs to break the gridlock, or
Washington will become ever more extraneous to
the rest of the nation.
10
USA
STATE BUDGETS:
UNITED IN PAIN
The issue:
State governments are facing budget crises
It is not just the federal government that has a budget problem. State Budget Solutions, an advocacy group,
calculates that aggregate debt across the 50 states was nearly $4.2tn in 2012. The largest debts are held by
California ($618bn) and New York ($300bn).
How we got here:
The cost of pensions is crippling some states
Market-valued unfunded public pension liabilities now make up more than half of all state debt. Illinois state and
local pension debt is now one-third of its gross product. Municipalities are also being dragged down by pension
liabilities. San Bernadino in California stopped making contributions to the state employees’ pension fund, after
filing for bankruptcy in October 2012.
What happens next:
Without reform, cuts to services inevitable
The aftermath of Sandy demonstrated just how big a role states have in providing the services and infrastructure
citizens rely on. Hardening key infrastructure against extreme weather should be a major priority for state
governments. This would provide an economic stimulus to the construction industry, helping spur the economy.
But the kind of capital intensive, long-term investment required will be hampered if state budgets are in a mess.
We asked two experts for their views on state finances in 2013. They warned that in the outlook was grim for
many states, with cutbacks in services, lay-offs and even capital flight in prospect.
Viewpoint:
Bob Williams, President, State Budget
Solutions
If governors and legislators continue to fail to
understand the scope of the pension crisis
and delay action, it will set taxpayers up for a
much bigger catastrophe in the future. Failing
to make meaningful reforms to pensions now
will result in future cuts to essential public
services – public health, safety and education
– and dedicated government workers being
laid off. It is vital to reform public pensions
now. Real reform must be based on actual
numbers instead of optimistic outlooks based
on unrealistic assumptions.
Viewpoint:
Will McBride, Chief Economist, Tax
Foundation
Certain states are going over their own voter-
induced fiscal cliff, particularly California and to
a lesser degree Illinois. This will result in flights
of capital and labour from those states. I expect
to see more municipal bankruptcies in 2013.
USA
11
STUDENT LOANS:
NOT MAKING THE GRADE
The issue:
Serious delinquencies are on the march
While the US economy is still slowly recovering from the subprime mortgage crisis, another debt bubble may be
lurking. A recent New York Federal Reserve report on household debt and credit showed that the fastest growing
sector in US consumer debt is student loans
i
. According to the New York Fed, outstanding federal student loan
balances increased to $956bn dollars at the end of Q3 2012, an increase of $42bn for the third quarter alone.
Worryingly, the delinquency rate for student loan balances has increased substantially this year, despite changes
made to the rules to ease repayment terms in 2011. The percentage of student loans that have been delinquent
for 90 days or more has risen from 9 per cent to 11 per cent. It has now overtaken credit cards to become the
most delinquent form of credit. (See Box 3).
Box 3
03:Q1 07:Q104:Q1 08:Q105:Q1 09:Q106:Q1 10:Q1 11:Q1 12:Q1
Source: Federal Reserve Bank of New York
Credit Card
Student Loan
Mortgage
HE Revolving
Auto
0
3
6
9
12
15
Percentage of loans 90 days or more delinquent, by quarter
Percent
Year (20XX):Quarter
12
USA
How we got here:
Attending college – the other American Dream
A university education was once reserved for a
wealthy few who went on into a select range of
professions. That has changed over recent decades.
On the supply side, higher education has become
more accessible due to the wide availability of loans
and financial support. On the demand side, a college
degree has become a requirement for an ever wider
range of jobs. These dynamics have driven a surge in
the cost of tuition. But with the economic slowdown,
there are more unemployed or underemployed
graduates carrying a heavy burden of student debt.
What happens next:
A bubble about to burst?
This is a huge but surprisingly poorly understood
credit market. Unlike mortgage credit, student debt
is not dischargeable in a US bankruptcy court. On
an individual level this means borrowers are forced
to deal with the long-term consequences of having
a bad debt on their credit record. This affects their
ability to fund large purchases such as cars and
homes. At a macro level, the federal government
is by some margin the largest provider of student
loans. This opens the possibility that the government
has to use taxpayer dollars to carry increased credit
risk on the student loan book. Keep watching those
delinquency rates in 2013.
“With college enrolments increasing
and the costs of attendance rising,
this balance is expected to continue
its upward trend. Further, unlike other
types of household debt such as credit
cards and auto loans, the student loan
market is incredibly complex.”
Federal Reserve Bank of New York
USA
13
SHALE ENERGY:
AMERICA’S GET OUT OF JAIL FREE CARD
The issue:
Shale gas – a potential game changer
Geopolitical uncertainty in Africa and the Middle East and competition for resources from new world powers like
China are worries for strategists in Washington. America’s thirst for foreign crude oil – of which it is the world’s
largest importer – means that its economy is highly exposed to volatility in global oil prices.
But technological developments in drilling mean that the US is on the verge of an energy revolution. The US
may have such vast deposits of shale gas and oil that it could be completely energy independent by 2035, and
become one of the world’s largest exporters of liquefied natural gas.
How we got here:
Vast discoveries of shale gas deposits across
continental US
A drilling technology called hydraulic fracturing, or
‘fracking’, has allowed energy producers to drill for
natural gas in shale deposits that were previously
inaccessible. Fracking has become one of the fastest
growing industries in the US, centred on areas where
there are large gas fields such as North Dakota and
Appalachian Mountain states like Pennsylvania.
What happens next:
Drill baby, drill?
The shale boom will not be big enough to offset the cost of inaction on the federal budget. But it could be a new
cornerstone for America’s economy. It will also fundamentally alter the global energy market. Saudi Arabia is
already lowering its crude production in response while Europe may one day be able to import natural gas from
the US instead of Russia.
However, the extent to which this happens depends on whether political leadership is willing to fully embrace
this controversial drilling method. The domestic energy industry is rarely far from political conflict. The Gulf oil
spill and the controversy over the construction of the mammoth Keystone XL pipeline show the difficulties of
balancing economic growth against potential environmental damage.
President Obama has supported the effort somewhat as part of his ‘all of the above’ approach to energy. But
fracking is strongly opposed by environmental groups – and many in his own party – who believe that the
process can poison groundwater and release high levels of greenhouse gases.
This sets the stage for a battle between those who see a huge economic stimulus in shale energy, and those
who see profiteering at the cost of the environment. This battle has already started to play out in Pennsylvania,
which now allows drilling, and New York, where it is currently banned.
“Shale gas is expected to support one
and a half million jobs, and contribute
nearly $200bn to GDP by 2015. By
2035, those numbers are expected to
double.”
Speech by Jack Williams, President, XTO Energy
14
USA
Where next for the GOP?
While its electoral coalition tends
to serve it well in the House,
Mitt Romney’s dominance in the
white male demographic was
not enough to get him elected.
The party will need to reach
out to growing populations –
such as Latinos – to take back
the White House. But this will
require a policy rethink which
may not go down well with the
party faithful.
Supreme Court
The President will be in a
position to appoint at least
one judge in his second term.
The Court has made decisions
on several major areas of
public policy in recent years
including campaign finance
and healthcare. It is set to hear
a significant case challenging
affirmative action in the New
Year. The ability to appoint a
liberal justice will be one of his
main legacies.
Dodd-Frank
The implementation of this
mammoth reform of financial
regulation rolls on. Rulemakings
will continue to reshape the
US finance industry, making
the country less welcoming to
foreign institutions and cutting
the profitability of domestic
ones. Whether the industry
will be ‘safer’ remains to be
seen. Duplicative regulation is a
serious worry, as the US and EU
fail to see eye-to-eye on mutual
recognition of regulatory and
supervisory structures.
New faces
Several key members of
Obama’s administration are
stepping down. These include
Secretary of State Hillary Clinton
and Treasury Secretary Timothy
Geithner.
Immigration reform
Latinos are the fastest growing
population in the US. Democrats
are supportive of reform, which
has attracted Latino voters to
their ticket. Reforms could also
permit more foreign high-skilled
workers into the US which
business groups such as the US
Chamber of Commerce strongly
support.
ON THE AGENDA –
THINGS THAT WILL DRIVE THE DISCUSSION
IN 2013
15
UNITED KINGDOM
THE COALITION:
CAN THEY GO THE DISTANCE?
The issue:
Cracks emerging in relationship
The coalition agreement between the centre-right Conservatives and the centre-left Liberal Democrats in 2010 was
designed to last five years. After a torrid 2012, tensions between the two parties create a possibility that the coalition
government could break up in 2013, or more likely in 2014, over irreconcilable differences on the economy and
Europe.
Viewpoint:
Patrick Nolan, Chief Economist, Reform
In the UK the key thing is public finances. There is probably going to be a spending review which will move
forward from 2014 to 2013 and, of course, the election is coming up, so people are going to be thinking
about manifestos. That means there is going to be a lot more debate around public finances, the impact
of austerity on the economy, how that translates to spending plans and how parties should be positioning
themselves prior to the election.
How we got here:
Gaps between parties getting harder to bridge
The senior leaders of the coalition are known as ‘the quad’
(see box 4). They remain committed to the coalition and to its
objective of deficit reduction.
However, some of Liberal Democrat leader Nick Clegg’s flagship
policies have been derailed by Conservative rebels, weakening
him. As a result he is now willing to veto Conservative policies.
Nevertheless the relationship in the quad remains constructive.
But outside of it, the cracks are deepening.
Within the Conservative party, old divisions on Europe are coming
to the fore. One hundred of Cameron’s MPs are now willing
to vote against the government on EU matters, removing the
coalition’s majority at a stroke. This is in sharp contrast to the pro-
Europeans on the Liberal Democrat benches.
Meanwhile, Liberal Democrats fret about their dreadful poll numbers which they partly blame on their association with
the Conservatives. An ICM poll released on 20 November had the party losing around half of their seats in the House
of Commons
ii
. Some of the left-leaning party base, who had never bought into the government’s austerity agenda,
would like to depose Mr Clegg and demand renegotiation of the coalition agreement or even complete withdrawal.
David Cameron,
Prime Minister
(Con)
George
Osborne,
Chancellor
(Con)
Danny
Alexander,
Chief Secratary
to the Treasury
(Lib Dem)
Nick Clegg,
Deputy
Prime Minister
(Lib Dem)
Box 4 The Quad
16
UK
What could happen next:
Staying together for the children, or ugly divorce?
There is no doubting that storm clouds are gathering over the coalition. The next 12 months have the potential to
give malcontents on both sides plenty of fodder. Many of the deepest spending cuts are set to bite in 2013. Worse,
the autumn statement revealed that the government is far off its deficit reduction targets, extending austerity to 2018.
There are Liberal Democrats who wonder if it is better to get out now, rather than risk electoral annihilation in the
future, as they become ever more deeply identified with austerity.
Then there is the UK’s relationship with the EU, an issue on which the Conservative party has a history of internecine
warfare and where the two parties share almost no common ground. The Liberal Democrats are worried about
drifting away from Europe; many Conservatives would like nothing less. This issue will no doubt see more backbench
rebellion and the erosion of the coalition’s voting majority. The Conservatives are also looking nervously at the UK
Independence Party (UKIP), an anti-EU party who are polling nearly 10 per cent of the public vote, with support
drawn mainly from jaded former Conservatives.
What would happen if the coalition became untenable? One possibility is that the Conservatives would form a
minority government, possibly negotiating a ‘confidence and supply’ agreement with the Liberal Democrats to help
pass essential legislation such as the annual budget. Such an arrangement could be highly volatile and would be
likely to unnerve business and markets which have tended to buy into the coalition’s stable commitment to deficit
reduction.
Box 5
Labour
Liberal Democrats
UKIP
Other
Conservatives
YouGov/The Sun poll 4/12/12
Election
Results
May 2010
29%
23%
36%
3%
9%
Latest
Polls
Dec 2012
44%
11%
30%
10%
5%
2010 election results vs latest polls
UK
17
The second possibility is that an early election is called following a two-thirds vote in the House of Commons. Polling
indicates that Ed Miliband’s Labour party would emerge as the largest party
iii
. Labour would attempt to slow down
the deficit reduction process, though in general their policies are underdeveloped. If the transition was quick and
the new government was considered credible by the markets, the impact of a change in government might only be
fleeting.
Are these likely outcomes? The commentators we spoke to said that the potential costs of torpedoing the coalition
for both the Liberal Democrats and the Conservatives were too large. First, why create the possibility of an election
when defeat for both parties is assured? Second, Cameron and Clegg have a great deal personally invested in this
project and in many respects are more closely aligned with each other than they are to fringes of their own parties.
It is more likely that the coalition will stay together over 2013, but by 2014’s European elections – where the Liberal
Democrats will fare poorly nationally and UKIP may well come first – tensions may reach an untenable level causing
an early coalition break-up. In the interim, the marriage is becoming a rockier one. So while 2013 might see the
coalition try to hold it together, by 2014 it could end in a messy divorce.
Viewpoint:
Senior executive at leading
business association
The risk is that the actual deals
being struck behind the scenes to
ensure that the coalition actually
works will be more difficult to
make, especially with the pressure
from the Tory right.
Viewpoint:
Anne Richards, Chief
Investment Officer, Aberdeen
Asset Management
If they break-up and and an
election was called, it is not clear
that the Tories would win an
outright majority. In the current
prevailing mood I think the Lib
Dems are in such a weakened
position that the only thing they
can do is cling onto the vestiges
of power in the hope that they
may be able to sway some vote-
winning policy in their direction by
2015.
Viewpoint:
Stephen King, Chief
Economist, HSBC
I personally think a coalition
breakup is unlikely; only because
both parties have everything to
lose by having an early election
and little to gain. It is a strange
marriage where everyone can see
the disadvantages but at the same
time it is better to stay together for
the sake of the children.
18
UK
How we got here:
Monetary easing has failed to counterbalance austerity
The response of the coalition government to Britain’s economic malaise has been to implement a programme of
spending cuts and tax rises to reduce the deficit and maintain market confidence. To stimulate economic activity and
offset the contractionary forces of austerity, the Bank of England has increased the supply of money in the economy
through quantitative easing.
But economic growth has not been forthcoming.
Turbulence in the eurozone continues to hurt the UK
economy. Weaker than forecast tax receipts mean that
the Chancellor could miss his borrowing target by £13bn
in 2012. The government’s autumn statement saw the
announcement of below-inflation benefit increases in
the coming years to help meet deficit reduction targets.
Austerity is to be extended until 2018, far beyond the next
general election.
Meanwhile, the cost of living has continued to rise steadily,
while wages have not kept pace. This has resulted in an
extended squeeze on living standards for working families.
UK official statistics show disposable incomes fell 4.3 per cent
on average for the middle fifth of households – £1,100 per
household between the financial years 09/10 and 10/11.
At the same time that ordinary families are struggling, there is evidence that low social mobility is becoming
problematic. Government adviser and former Labour minister, Alan Milburn, published a report in October 2012
stating that social mobility is ‘flatlining at best’ and could even be reversed unless educational opportunities are
improved for poorer students.
It’s only just begun?
The Institute for Fiscal Studies has estimated
that by the end of 2012, only 12 per cent of the
government’s austerity measures will have been
implemented.
According to the recent Austerity Tracker Poll,
59 per cent of households believe they have not
been impacted so far.
61 per cent said they expected to be hit by the
cuts in 2013.
Almost half (48 per cent) said they disagreed
with the Government’s austerity programme.
Viewpoint:
Patrick Nolan, Chief Economist, Reform
[Civil unrest] will certainly happen in the eurozone, but does that get imported into the UK? [There are] very
different economic conditions of course, but certainly when you look at what countries like Greece and Spain
are going through, I certainly think those issues are going to arise and you can see that by the share of votes
that is going to relatively fringe parties.
THE CUTS:
AT WHAT COST?
The issue:
Does flat-lining economy + government spending cuts = year of discontent?
Greece and Spain have seen widespread social unrest as a result of deep austerity. While the UK has not witnessed
such scenes, the last couple of years have seen a marked increase in industrial action and organised protest against
government policies. There were 1.4 million days lost to strikes in 2011, the highest number since 1990. The
coming year will see the implementation of some of the government’s most severe cuts. Worse still, outgoing Bank
of England Governor Mervyn King appeared to suggest in November that country is only half-way through a ‘lost
decade’. Could that translate into similar unrest on the streets of Britain?
UK
19
What could happen next:
Full steam ahead, or change in course?
Could a perceived lack of opportunity combined with a decline in living standards translate into increased civil unrest
and extensive industrial action when the full effect of the cuts is felt in 2013?
Unless there is economic growth to show for the pain of austerity – or least the prospect of it – the answer must be
that it is a serious possibility.
Increased unrest would lead to further economic headwinds for the economy, in the form of work days lost due to
strike action and reduced consumer spending. It could discourage investment, depress house prices and increase
unemployment.
The country is currently divided over the austerity programme. One possible bright spot is that the UK’s economy is
predicted to grow by 1.2 cent next year, more quickly than any of the major economies in the eurozone. This may
vindicate the Chancellor and put him in a position to argue for continuation of the austerity plan. But if there is no
growth, the Chancellor’s strategy will likely cause widespread discontent and a new approach may be required. The
departure of the Bank of England’s Mervyn King, an architect of the strategy, may be an opportunity for this change.
Osborne himself will be under increased pressure in 2013. Though his recent autumn statement was received far
better than his previous budget, the UK remains on a negative ratings outlook from all major credit rating agencies.
The Chancellor will have to deliver a convincing set of measures this spring in order to guarantee his job through to
the next election.
Estimated and projected UK GDP growthBox 6
Estimated and projected UK GDP growth
Source: HM Treasury
-0.5
2011 2012 2013 2014 2015 2016 2017
1.0
0.5
1.0
1.5
2.0
2.5
3.0
Per cent
0.9%
-0.1%
1.2%
2.0%
2.3%
2.%7 2.8%
Year
Viewpoint:
Stephen King, Chief Economist HSBC
A lot of the cuts will materialise more forcibly over the next year or two and that’s when things will begin to
bite...The problem here is not so much the cuts in isolation, but that there is no recovery because the whole
idea originally is that you aim fiscal policy at delivering austerity and you aim monetary policy at delivering a
recovery and activity. The main surprise over the last year or two isn’t the intensity of the fiscal policy but rather
the impotence of the monetary policy.
20
UK
“We always have to do something that
will stand up to public opinion back
home...Despite differences that we
have, it is very important for me that the
UK and Germany work together”
Angela Merkel makes common cause
with David Cameron on the EU budget in
November 2012
UK AND THE EU:
DRIFTING APART?
The issue:
As eurozone integrates further, Brixit from EU increasingly a possibility
While the ongoing eurozone crisis has drawn its members towards closer political and economic integration, the UK
is increasingly an outsider. The tone of public debate in Britain has become increasingly eurosceptic and a referendum
on the UK’s relationship with the EU could be announced in 2013. Many Conservatives have long dreamt of a
repatriation of EU powers, with many Tory backbenchers preferring outright withdrawal from the union. With public
discontent towards Europe growing, these eurosceptics sense that their moment has arrived. If the UK powers ahead
with plans for a referendum on the issue, it risks drifting away from the continent and losing its place at the EU table.
How we got here:
The rising tide of euroscepticism in the UK
Economic dislocation in the eurozone has strengthened the voices of those who want the UK to reassess its
relationship with the EU. Notably among them are a cadre of rebellious and vocal Tory backbenchers elected in 2010.
They are disenchanted by the political dynamics of the Con-Lib coalition and are becoming increasingly restive.
For his part, David Cameron’s line on Europe is deliberately ambiguous. He knows how important the single market is
for British business, with the EU accounting for 44.5 per cent
iv
of all UK exports so far this year. But, equally, he must
be seen to be taking a robust line on Europe to calm his backbenchers and prevent the UK Independence Party from
attracting Tory supporters. To placate eurosceptics he has pledged a referendum on any European treaty change that
would increase the power of Brussels.
UK
21
Viewpoint:
Anne Richards, Chief Investment Officer,
Aberdeen Asset Management
I believe the UK’s relationship with the EU is viewed
differently among member countries. Finland, for
example, is also part of the eurozone but has very
different priorities to the periphery and is not willing to
write blank cheques to other countries like Germany.
Therefore, I think there are going to be opt-outs of
some shape or form from other countries in the EU
too.
Viewpoint:
John Greenwood, Chief Economist, Invesco
It is becoming increasingly important for Britain to
define a relationship with Europe which involves
economics, trade and finance, but leaves some social
areas of policy out of that. However there are some
politicians who want to buy the whole package:
human rights, immigration, civil liberties. This impacts
on the stability of coalition and the UK’s relations with
other European countries. Unless Cameron, Hague
and others can outline more clearly the range within
which they want to maintain the relationship and then
separate out other areas there is plenty of potential for
conflict with other European countries.
There are two running sores which complicate Britain’s relationship with the EU. First is the six-yearly EU budget deal.
Thanks to an opportunistic alliance between Labour and Tory rebels, parliament has called for a reduction in the UK’s
contribution in a non-binding vote. The government is negotiating for a freeze, saying that it unfair to impose austerity
at home, while giving more to the EU. Countries which benefit from agricultural subsidies and regional aid from the EU
strongly disagree and say that UK is being disingenuous as it already enjoys a 35 per cent rebate on its contributions.
For David Cameron, any deal that increases contributions would be a huge failure in the eyes of his party and would
increase clamour for a fundamental change in the UK’s relationship with the EU. But Cameron has found an ally in
Germany’s Angela Merkel, which strengthens his position and increases the chances he can secure an outcome
acceptable to public and party opinion. The budget deal should be completed in early 2013, giving us an indication of
shifting relationships within the EU and their likely impact on future negotiations.
The second issue is the protection of the UK financial services industry from EU policies that might undermine its
global competitiveness. The sector delivered a trade surplus of £46.7bn in 2011
v
, and remains a cornerstone of the
British economy. While the banking sector is hardly popular at home, its interests are still jealously protected at the EU
level. Cameron used his veto in December 2011, derailing an entire EU summit in an attempt to extract guarantees
on the protection of the UK financial services industry. A proposed European Financial Transactions Tax (FTT) dismays
bankers. This tax, combined with the possibility that a new European Banking Union demand that euro-denominated
transactions take place in the currency zone, rather than London, would seriously undermine the City of London.
Since Cameron used the veto, the government has walked a narrow line, looking to maintain access to the single
market while choosing to opt-out of many eurozone initiatives. The government has had some measure of success
but over time this approach will inevitably see the UK drift further from the eurozone core.
What could happen next:
A referendum in the offing?
David Cameron has said there will not be a referendum on the EU until after the election in 2015, though he will likely
announce further details about the shape of this referendum – what the question will be and the date it will take place
– in early January next year. This may take some of the momentum away from UKIP. Either way, a public referendum
on the issue is not a question of if, it is a question of when.
When the future referendum occurs, the question posed to the public will be crucial. If the question is simply an ‘in’ or
‘out’, a recent poll
vi
found that a majority would vote for an exit (see Box 7).
22
UK
At present the more likely option is a two-question
poll similar to that formulated by former Foreign
Secretary Lord Owen: one on remaining part of
a renegotiated ‘European Community’ based on
trade, and a second on staying in a more integrated
EU.
Some have suggested that the UK could enjoy a
looser relationship with the EU like Switzerland or
Norway, which is not politically realistic. The EU has
already said there will not be another country treated
like Switzerland, which has arguably gained access
to the Single Market on easy terms, while Norway
complains that it has to implement EU rules without
having any say in how they are written.
In either scenario, business will be nervous about
whether UK access to the EU single market is
compromised. While business grumbles about the
weight of EU regulation, they also benefit from open
access to European markets. The UK having to
tediously renegotiate access to these markets, most
likely on less favourable terms, would be bad for
business.
The Foreign Office is already conducting a study on the ‘Balance of Competences’ between the EU and UK with
a view to measuring how important the EU is to trade and investment, as well as how well the EU is carrying
out its duties. The fact that the study is being conducted at all is significant and its findings will no doubt throw
further petrol on the flames.
If Cameron were truly in favour of leaving the EU he would call an in/out referendum now. Fortunately for
business, and his pro-European Liberal Democrat partners, he is not, and he will not. The EU’s recent budget
debates have to some extent changed the game. Fiscally conservative, free-market economies have formed
alliances, in turn giving the UK more bargaining power and helping to regain its place at the decision-making
table, where Cameron needs to stay to be able to make a pro-EU case to sceptical British voters. The worst
case is that the UK drifts out of the EU without any credible strategy in place for its future in a tough global
economy.
Box 7
In
Out
Don’t know
EU
referendum
poll
Nov 2012
44%
48%
8%
Source: Ipsos MORI, November 2012
If there were a referendum on whether
Britain should stay in or get of the EU,
how would you vote?
Viewpoint:
Stephen King, Chief Economist, HSBC
If Cameron were to give the British people a choice
of staying in, renegotiating our agreement or leaving,
I think we’d end up leaving, which isn’t really what
Cameron wants.
Viewpoint:
Viewpoint: Head of government relations, leading
investment bank
The UK Independence Party seem more a party the
Conservatives can’t ignore – if they split the Tory vote
talking about things the Tories don’t want to talk about
for internal reasons, it is very challenging.
UK
23
Mark Carney takes over as
Governor of Bank of England
The central bank gets a new
leader with a host of new
powers over financial regulation.
Carney has suggested
scrapping inflation targeting
and replacing it with measures
based on growth or jobs.
The UK’s AAA credit rating
The UK is now on negative
outlook from all three major
ratings agencies. In 2013 it
is likely that at least one will
downgrade the UK, a serious
blow to Chancellor George
Osborne’s economic credibility.
Scottish Independence
With a referendum set for 2014,
next year will see the ramping
up of the discussion around
the pros and cons of Scottish
independence. Once again,
expect to see Europe a big part
of the debate, as accession to the
EU is a key plank of the Scottish
National Party’s strategy for
independence.
Banking reform
As the ink dries on legislation
finalising the new financial
services regulatory structure,
2013 will see progress on
legislation to reform the banking
sector. Debate will focus on the
‘ringfencing’ of retail operations
from investment banking
operations.
Tax
Debate will continue to rage
about the corporate tax system
in the UK and in the EU.
ON THE AGENDA –
THINGS THAT WILL DRIVE THE DISCUSSION
IN 2013
EU
24
EU
THE EUROPEAN UNION
EUROZONE: WHEN THE FIRE IS OUT, WILL
LEADERS SEE THROUGH THE SMOKE?
The issue:
Eurozone leaders lose their sense of urgency and fail to finalise reforms
For the past two years eurozone leaders have been in crisis management mode, attempting to contain the
acute crisis caused by flaws in the design of the Economic and Monetary Union (EMU). Risks to the future of the
eurozone remain, despite the recent relative calm in the markets. In the absence of imminent catastrophe, might
leaders be lulled into a false sense of security in 2013 and leave essential reforms unfinished?
How we got here:
Market lull allows breathing space
While the impacts of the eurozone crisis are primarily economic – dismal growth, poor credit conditions and
high unemployment – much of the underlying problem is embedded in the politics of crisis management. The
troubles began as a sovereign debt crisis in a small euro area state. But the lack of decisive action by the rest of
the eurozone has turned this into a chronic political and financial crisis. Businesses and markets have called for
a ‘big bazooka’ strategy to create certainty. Instead, eurozone leaders have followed a piecemeal approach of
strengthening central control of economic policies.
This has led to some progress. The so-called ‘six pack’, which has tightened restrictions on government debt
and deficit levels in the Stability and Growth Pact, has now been in force for a year. In addition, the Council of
Ministers and the European Parliament are about to close a deal on the ‘two-pack’ of additional regulations
giving even more powers to the European Commission to intervene in national budgetary processes. At the
same time, the European Central Bank is set to gradually take over the oversight of all banks in the eurozone,
enabling the European Stability Mechanism (ESM) to inject capital directly into the banking sector instead of
channelling this aid through governments, thereby breaking the negative feedback loop between banking and
sovereign risk. However, EU institutions have not fully succeeded in convincing the markets about the efficacy or
consistent application of these tools.
As such, there is a widespread view that the ESM and the European Central Bank’s actions have provided the
currency area with temporary breathing space only. Many difficult political decisions still lie ahead. It is far from
clear whether the eurozone emerges from the crisis as a fully integrated and reformed currency area, as an
incomplete work, or whether it collapses entirely.
Viewpoint:
Senior Official, EU
The steps already taken to strengthen the Economic and Monetary Union during the past three years are historical
and their impact should not be underestimated. The Member States are implementing reforms both on the fiscal
and on the structural side. The challenge comes from the short term negative effects of these reforms which create
political and social pressure. The year 2013 will be a political acid test. The first half will be very difficult as the reforms
take time to translate into economic benefits, and there is a real risk that political instability could further postpone the
return to growth.
EU
25
Source: The 2012 Euro Plus Monitor – The Rocky Road to Balanced Growth
(The Lisbon Council and Berenberg Bank)
Box 8
Cyprus
Greece
Portugal
France
Italy
Spain
Ireland
Malta
Belgium
Finland
Austria
Slovenia
Slovakia
Netherlands
Germany
Luxembourg
Estonia
0 2 4 6 8 10
More reform required across eurozone countries
Adjustment Progress Indicator Fundamental Health Indicator
The adjustment progress indicator and the fundamental health indicator give an
indication of the effort made by countries to correct their fiscal problems as well as the
country’s overall economic health.
The higher the score, the more has been done or the better the country’s health. Whilst
Greece, Portugal and Ireland have been forced into adjustment, it is remarkable how poorly
some of those countries not in crisis score, according to the Lisbon Council.
26
EU
What happens next:
Without continued reform, could Europe drift back into crisis?
After two years in crisis mode, the next source of political risk may have a rather surprising source: relative calm
in the markets. The only thing that has galvanised decision-makers into action so far has been the risk of an
imminent disorderly sovereign default and the chaos that would follow. The current situation, with the ESM in
place and an ECB commitment to support bond markets, must feel like holiday season for European leaders. It
would be tempting to put painful and tedious reforms of EMU on the back burner.
However this would be a mistake, as half-baked reforms will leave the eurozone ill-equipped to handle looming
problems in politically sensitive areas such as competitiveness, ageing populations, structural reforms and the
mutualisation of debt. Furthermore, the direct recapitalisation of Spain’s banks by the ESM is postponed until the
single eurozone banking supervisor is fully functional, or until the creditor countries give their consent.
It would be unfair to say that the eurozone has not come a long way in the past two years in terms of
strengthening the oversight of public spending and addressing some of the systemic weaknesses at the heart of
the current crisis. But the world needs to be convinced that the eurozone can take a proactive approach, rather
constantly fighting fires.
Viewpoint:
John Greenwood, Invesco
In my view, a country will leave the eurozone, but
over the next two-to-three years. This could occur by
adverse political results such as austerity fatigue in
southern Europe or bailout fatigue in the north leading
to the election of an extreme party who reject the
orthodoxy of staying in the Union. Or it could be caused
by an acceleration of last summer’s run on the banks,
which outstrips the ability of bureaucrats, politicians or
central bankers to keep it under control. The core of the
monetary union will survive. There is huge political and
other capital invested there so it will be kept together.
However the cost of keeping peripheral countries in
will be huge, namely after many years of stagnation
whilst they deflate their economies until they become
competitive again.
Viewpoint:
Karel Lannoo, Director, Centre for European
Policy Studies
The eurozone has the tools now – six pack and
two pack – but they are not consistently applied
to all member states, for example France.
Viewpoint:
Holger Wessling, General Manager, DZ
Bank AG
[The crisis] will speed up European integration
– what we have seen politically in Europe is that
most of the integration has been driven by various
external pressures or events…When you look at
how much legislation and change is being driven
through Brussels at the moment, I think they’ve
done in two years the amount they did in the
previous ten. Having said that, I do fear that we
might leave the man on the street behind. We need
to explain to the voters, the people of the European
Union, better what’s actually happening and how
they will benefit.
EU
27
NATIONAL ELECTIONS THAT COULD CHANGE
THE COURSE OF THE EUROZONE
The issue:
Germany and Italy head to polls with eurozone front and centre
2013 will see two critically important elections take place in the eurozone: Italian elections in February and
German elections in September. These elections are crucial to the future of the eurozone.
How we got here:
National politics will have far-reaching effects on the rest of the eurozone
Despite the considerable power and influence of the EU institutions, policymaking within the bloc is still largely
driven by politics at member state level. This can make domestic elections, particularly in the large countries,
crucial.
Germany plays the role of reluctant leader of the troubled eurozone. Chancellor Angela Merkel has staked her
political future on ensuring German taxpayers are not on the hook for the cost of Greece’s economic meltdown.
This unbending position has won her 70 per cent approval ratings at home, but has made her unpopular with
European officials who think she has put domestic politics above the interests of the eurozone. The Greek
economy has shrunk by more than 6 per cent in 2012, and its total debt burden is on course to reach almost
twice its GDP by 2014. There is little prospect that the country can escape its troubles without further support
from the rest of Europe, particularly Germany. But if Merkel changes her position on Greece, it could kill her
chances in the election.
Meanwhile, Italy remains debt-laden, with a shaky economy large enough to bring down the entire eurozone
should it implode. Mario Monti’s technocratic government has restored some level of market confidence
by pushing through much-needed domestic reforms. But the rise in Italy’s bond yields following Monti’s
announcement that he will resign after the 2013 budget is passed, gives some flavour of the kind of reaction that
we could see after the elections. Political uncertainty is the last thing that the markets want to see now, but it is
possible that Italy will provide it in spades.
28
EU
What happens next:
German and Italian public have a big choice on their hands
There are two reasons why the forthcoming elections pose a political risk. First, the elections may change the
countries’ stances towards the EU at a time when crucial decisions need to be taken. The second is the chance
that elections could change domestic policies which then have a knock-on effect to the rest of the eurozone.
In Germany, it is likely that Angela Merkel will continue as Chancellor. The question is, with whom? Frau Merkel’s
current CDU/CSU/FDP coalition may falter even before the election. Regional elections in January could see her
lose a majority in the federal Senate, meaning that laws could be effectively overturned by the socialist SPD and
Greens in the upper house. Nationally, a December poll for the Bild newspaper showed Merkel’s coalition with
42 per cent support, the same level as combined support for the SPD and Greens. This close race opens the
possibility of a grand CDU/SPD coalition in 2013.
What might happen after the German elections? With voting out of the way, the government may be more willing
to take the unpopular decisions that are needed to lift the eurozone out of its current mess. The other possible
scenario could be that Merkel takes the election victory as a mandate to continue with her current tough policies
and that little will change.
A major turnaround in Merkel’s policies on the eurozone seems unlikely. As German socialist MEP Peter Simon
noted in December 2012, the next election is always just around the corner; after the 2013 national elections 16
state level elections will follow. This will prevent leaders from straying too far from public opinion.
In Italy, the election result is unpredictable. Centre-left Democrat candidate Pier Luigi Bersani’s clear-cut victory
in the primary run-offs on 1 December 2012 seemed to solidify his place as frontrunner to succeed Mario
Monti as Prime Minister. However, the political scene has changed rapidly over the course of December. Silvio
Berlusconi may throw his hat into the ring, while European leaders are reportedly imploring Monti, whom they
trust and respect, to run on a platform of continuity.
Opinion polls show the Democrats well ahead, with support of about 30 per cent of the electorate, profiting from
the disarray in Berlusconi’s People of Liberty party, which is trailing at 16 per cent.
In all probability, no lasting solution will be found to the systemic economic problems facing the eurozone,
particularly in terms of additional decisions on Greek debt before the German election is safely out of the way.
Eurozone partners and debt markets will also be watching Italy’s elections closely. If it looks like the progress
made by Monti is at risk of being reversed, the outcome may be grim. The voters of Germany and Italy have a
big choice to make in 2013.
EU
29
Box 9 EU Member States where the incumbent Government has lost power (2009 onwards)
UK
Spain
Italy
France
Romania
Netherlands
Greece
Finland
Malta
Slovakia
Slovenia
Denmark
Portugal
Belgium
Ireland
Hungary
Germany
Poland
Lithuania
Estonia
Austria
Luxembourg
Sweden
Bulgaria
Latvia
Czech republic
Cyprus
Leadership that has changed Leadership that has survived
30
EU
Viewpoint:
Anne Richards, Chief Investment Officer,
Aberdeen Asset Management
Going into 2013 parliamentary elections in Germany
will be a key event in the developed world. The
future of the European banking sector, the euro and
the European sovereign bond markets will depend
on Germany’s willingness to continue to accept the
role it has held so far held. There is the potential for
a surprise result as so far in virtually every European
election we have witnessed fringe parties gaining
support for not supporting austerity measures.
Viewpoint:
Holger Wessling, General Manager, DZ
BANK
Unless we see any major external shocks,
possibly resulting in increased German
unemployment, I think that Chancellor Merkel
herself carries sufficient goodwill in the population
to be re-elected. It’s less the case for her party;
she will carry the so-called Chancellor bonus,
which I think will most likely get her through, but
I would think it will be a tighter majority for the
existing coalition government of CDU/CSU and
FDP.
Viewpoint:
Viewpoint Karel Lannoo, Director, Centre for European Policy Studies
What will happen in Italy is difficult to predict. In Germany, Merkel will face the additional challenge of controlling
different factions of her own party.
A PROTECTIONIST SHIFT
The issue:
Will the EU start raising economic barriers?
The economic crisis has forced the EU to focus its
efforts on internal issues. Rising unemployment
and public discontent have brought about changes
in government in many EU countries. In the face
of economic weakness, will politicians adopt an
increasingly protectionist agenda? And are we
witnessing the emergence of a more inward-looking
European Union?
How we got here:
Crisis strengthens calls to protect domestic industry
The economic crisis has fuelled public discontent with incumbents. As a response, we have seen the rise of
populist and nationalistic voices in some parts of Europe, both in the weaker south and in the stronger north.
Some call for ‘less Europe’ and others for more protectionist trade policies. The first revision in 30 years of the
Generalised System of Preferences (the EU’s framework for preferential tariffs towards developing countries) was
concluded in October 2012 and as a result, many of the wealthier developing countries will lose their preferential
treatment. Meanwhile, France is trying to boost its troubled car industry not only through domestic subsidies but
also by requesting the EU to put its free trade agreement with South Korea, a major automobile exporter, under
surveillance.
“The EU is the only one that does not
protect itself against unfair competition.
We have become the idiots of the global
village,”
French Minister of Industry, Arnaud Montebourg
EU
31
In addition, the EU has focused much of its energy
on crisis management, arguably taking its eye off a
longstanding commitment to free trade, an area where
the EU has significant clout. The situation has not been
helped by stalled WTO negotiations, which have killed
the prospects of a comprehensive multilateral trade
agreement. Finally, one of the most vocal proponents of
trade liberalisation, the UK, appears to be drifting away
from the EU.
What happens next:
Hopefully, new trade talks come to a successful
conclusion
The single market is one of the greatest assets and
trade policy is one of the few areas where the European
countries speak with one voice. But an export-led
recovery driven by the many sectors where Europe has
a competitive advantage has seemingly been forgotten
by some politicians. Emerging economies which import
European luxury goods, cars and airliners are often
portrayed more as a threat than as an opportunity.
Giving in to calls for populist and protectionist measures
will only delay necessary structural reforms and hurt
those industries that remain competitive. In addition,
some of the policy responses to the eurozone crisis
could risk wearing down the competitiveness of those
industries that are dependent on a level playing field
with the rest of the world. The financial services sector
is one example where the popular pressure has taken
precedence over international competitiveness.
Even if these pressures are a temporary turn, they
may have longer-standing consequences than are
immediately obvious. The European Commission, the
EU’s representative in all trade negotiations, consists
of commissioners appointed by their respective
governments. Therefore, if the national governments
embrace more protectionist policies they may also be
inclined to support electing a cabinet of commissioners
sharing this approach. This commission will stay in
power between 2014 and 2019, which is much longer
than anyone would like to see the current crisis lasting.
Viewpoint:
Head of government relations, leading
European investment bank
Economic protectionism and nationalism both at
EU level and amongst individual states is a real risk.
We have a single market that seems to be under
huge pressures. The whole rationale of the EU is
to have free-flowing cross-border trade. But we
have been seeing defensive responses over the
past four years. There is talk of a US-EU free trade
agreement, but that is unlikely to happen, with
negotiations likely to last for many years. The whole
idea of a single market is quickly eroding. What we
are seeing is balkanisation with 27 governments
answerable to their taxpayers. This protectionism is
a severe challenge to the EU’s DNA.
Viewpoint:
Patrick Nolan, Chief Economist, Reform
Governments are much more likely to put short-
term national, political interest ahead of the
interests of a multinational company which is seen
as good for long-term growth... I think the hostility
of the environment makes regulatory coordination
more important, not less
“That governments resort to discrimination
against foreign commercial interests during
global economic downturns is well known.
“History shows that the forms of
protectionism tend to change during crises
and that such protectionism prevails well
after national economies have recovered”
Simon J. Evenett 11th Global Trade Alert Report
Optimists hope that a bilateral EU-US free trade agreement, currently under discussion, and an ambitious trade
negotiation with Japan will help the EU deliver a useful blow for enterprise and trade. While the US in particular
is not known for swift ratification of trade deals, and there are many sceptics about what will ultimately be
achieved, it is essential the EU shows that it remains open for business.
32
EU
Completing the Banking
Union
With the first pillar of the
European Banking Union – the
Single Supervisory Mechanism
– close to completion, the two
remaining elements, namely a
common resolution mechanism
and an integrated deposit
guarantee are equally important
to prevent future crises and to
avoid further fragmentation of
capital markets. However, these
will entail a much greater degree
of risk sharing and will therefore
be much more difficult to agree
on. In financial regulation more
widely, the ability of the EU
and the US to recognise each
others’ regulatory structures
and supervisory structures
is a serious worry that could
negatively affect cross-border
financial flows, with the pair
failing to see eye-to-eye on the
issue at present.
Conflicts in neighbouring
countries
Europe is close to many ongoing
and potential conflicts. A conflict
between Iran and Israel is
possible, while the civil war in
Syria is drawing the attention
of European leaders. The EU is
not known for its capabilities in
the field of foreign and security
policy. But more may be
expected from the Nobel Peace
Prize winning organisation in the
future.
Finalising EU’s long-term
budget
The negotiations to agree the
next Multiannual Financial
Framework for 2014-2020 are
stuck due to disagreement
between those wanting to spend
more and those not willing to
increase their contribution.
Agreement will have to be found
in 2013 and the outcome will
influence both the EU and its
Member State policies until the
end of the decade.
ON THE AGENDA –
THINGS THAT WILL DRIVE THE DISCUSSION
IN 2013
33
ASIA PACIFIC
MARITIME DISPUTES:
MAKING WAVES IN ASIA
The issue:
Tensions are rising over the South and East China shipping routes
The South and East China seas are very important shipping routes and are also home to large oil and gas
reserves. A major concern is that tensions arising from competing claims by bordering countries to these
resources could escalate into conflict.
Many countries in Asia – China included – are not energy sufficient and resource consumption is set to rise as
the region continues to develop. The Asian Development Bank predicts that Asia will produce in excess of 40 per
cent of the world’s greenhouse gas emissions within the next 10 years.
Viewpoint:
John Greenwood, Chief Economist, Invesco Perpetual
Hugely increased tension in Asia between China and Japan over the disputed islands means there is a
growing risk of clashes. That would be very disturbing to financial markets.
Box 10
Source: US Energy Information Administration
60
05 1108 14 1706 1209 15 1807 13 1610 2019
90
120
150
Consumption(QuadrillionBtu)
China’s energy consumption set to double on 2005 levels by 2020
vii
Year (20XX)
34
ASIA
The resource issue is so important that even India, which has no maritime claims in the area, has threatened to
use force if necessary to defend its commercial oil and gas interests off the coast of Vietnam. In early December,
Indian Navy Chief Admiral D. K. Joshi was reported by Reuters as stating that the Indian navy was preparing for
intervention if necessary.
The second issue is trade and maritime security. Home to
some of the world’s busiest and most important shipping
lanes, freedom of navigation is a strategic issue not just for
the countries bordering the seas but for the wider world.
How we got here:
A fractious history
The issue is complex and needs to be viewed in the context of historic hostility, much of it emanating from
the Second World War, and concerns, especially in Japan and south east Asia, about a more assertive China.
The key issue is Asia’s growth and the demand for resources. The South and East China Seas are resource-
rich, bordered by many countries, and maritime boundaries have not yet been defined. Maritime borders are
governed by the United Nations Convention on the Law of the Sea but this 1982 convention fails to resolve
ownership differences in the China Seas. A number of guidelines are in place, such as exclusive economic zones
but it is up to countries in the region to resolve overlapping maritime claims by negotiation, and no country in the
region is willing to give up its claims.
The issue is escalating politically, with the outgoing Secretary General of ASEAN warning that “we have to be
mindful of the fact that the South China Sea could evolve into another Palestine”. China has recently started
issuing new passports with a map claiming sovereignty over disputed territory. This has angered its neighbours,
particularly Vietnam and the Philippines, whose immigration officials refuse to stamp the new passports. In
December, Vietnam witnessed a series of anti-China protests – a country where protests are very rare. Similar
protests have taken place in Japan, stoking deep-rooted hostility between the countries. Protests are not
one-sided. In September, anti-Japan protests escalated in China following the purchase by the Japanese
government of the disputed Senkaku islands from a private Japanese owner. The demonstrations escalated to
such an extent that some Japanese businesses had to suspend operations in China on safety grounds.
What happens next:
The issue will remain firmly on the agenda
Despite attempts by China to remove the issue from agenda of regional gatherings such as the East Asia Summit, it
is not going away. The United States is bolstering its presence in the region and we are likely to witness an escalation
of tensions throughout 2013, especially in the East China Sea.
Japan-China relations are complex, and although there is much official rhetoric and grass-roots level hostility, it is
unlikely that either country would want to see the issue escalate into full-scale conflict. Trade and economic relations
between the two countries are too important to be compromised by the Senkaku islands. Japanese investment in
China is large, and China as a consumer market for Japanese products is increasingly important in an era when the
traditional export markets of Europe and the US are depressed.
The recent election results in Japan confirmed a victory for the nationalists, who will take a harder line against China.
Shinzo Abe, leader of the winning Liberal Democratic Party, immediately stated that “The Senkaku islands are
Japan’s inherent territory… There is no room for negotiation on this point”. In response China’s Ministry of Foreign
Affairs stated that it is “highly concerned about which direction Japan will take”. The LDP is unlikely to compromise
on the issue, and the Senkaku islands will be a thorn in the side of China-Japan relations for years to come.
“The risk of conflict in the South China
Sea is significant”.
US Council on Foreign Relations
ASIA
35
Viewpoint:
Sirpa H. Ikola, Board Member, European
Chamber of Commerce Singapore
Anti-Japanese sentiment in China, reinvigorated
by the current island disputes, has the potential to
cause instability in Asia.
Viewpoint:
Garich Lim Shington, Director, Seaward
Chemicals
China has huge and growing energy resource
needs. These needs cannot be met by energy
reserves in China alone, which is compelling China
to seek alternative sources of energy resources
and raw materials. The South and East China Seas
are reportedly home to vast amounts of resource
reserves and China is unlikely to compromise on
its maritime claims.
Viewpoint:
Chanunrat Thienviroj, Associate, Singapore-
based import-export company
The South China Sea issue is a major concern to
companies like mine, who rely on free and open
shipping lines. The status quo is fragile, and given
that most trade in the region passes through the
South and East China Seas, any conflict in the
region could have a drastic effect on intra-ASEAN
and intra-Asia trade flows. The election results in
Japan have definitely raised the temperature.
The United States will continue to monitor the issue and build its military capabilities in the region. This will
present difficulties for both Singapore and Australia who host US military bases. While both of their economic
interests lie with a resurgent China, they depend on the United States for security.
On a practical level, ASEAN, which has many members with South China Sea interests, has proposed the
establishment of a hotline with China to help diffuse tensions and misunderstandings involving the dispute.
What is clear is that the risk of escalation is high, and maritime disputes in the region threaten to overshadow the
regional trade, economic and political agenda throughout 2013.
36
ASIA
AN ASEAN-CENTRIC ASIA?
The issue:
Overlapping trade agreements and the future of ASEAN
The world economic crisis and resultant dampened demand in the West has led many countries in Asia to
reappraise their trade policy and economic policy. At the trade level, policymakers and politicians are working to
boost intra-Asia trade, which has historically been low. Measures are being put in place to boost the domestic
consumption of GDP and improve trade-related infrastructure (both financial and physical) to help Asian
economies trade with each other. Part of this process involves trade liberalisation and regulatory harmonisation
and the Association of South East Asian Nations has been leading the way.
ASEAN is fast becoming the region’s premier intergovernmental decision making forum. Although ASEAN’s
membership itself is limited to 10 South East Asian countries, the East Asian economic giants of China, Japan
and Korea meet on the sidelines as the ASEAN+3 grouping. ASEAN is becoming a catalyst for Asian integration
and at the recent East Asia and ASEAN Summits in Phnom Penh, Asian leaders agreed to pursue three
complementary trade agreements, with negotiations starting in 2013:
1. A trilateral free trade agreement between China, Japan and Korea;
2. A regional comprehensive economic partnership (RCEP) of East Asia (including ASEAN);
3. A consolidation and harmonisation of ASEAN+1 trade agreements, such as the ASEAN-China FTA (Free
Trade Agreement), the ASEAN-Korea FTA and the ASEAN-Japan Comprehensive Economic partnership.
What is clear about these three agreements/negotiations is that ASEAN is taking centre stage. It already has
FTAs with Korea, China, and a comprehensive economic partnership with Japan. Indeed Japan is engaging
significantly in the region. It provides substantial development assistance to South East Asia and provides
funding for many organisations, including the ASEAN Foundation.
As a region of over 500 million people, it is equally clear that South East Asia is fast becoming one of the world’s
most important consumer markets.
The political issues though are two-fold:
1. Can ASEAN, with its diverse populations, cultures and stages of development sufficiently integrate into a
truly single market and trading bloc?
2. The relative spheres of influence of China and the United States.
ASIA
37
How we got here:
Cautious integration
Asian regional integration, particularly around trade, has been a long process and is far from the levels of
integration we see in the European Union. Although the ASEAN has been around since 1967, it wasn’t until
the 1997 financial crisis that leaders in Asia became serious about regional economic integration. The 1997
crisis led to the development of the Chiang Mai Initiative Multilateralisation (CMIM), a multilateral currency swap
arrangement among ASEAN+3 to help member economies deal with future short-term liquidity problems. The
CMIM was the catalyst for further regional integration through the ASEAN+3 grouping, with South East Asia at
its core. However, significant challenges remain to the process of economic integration. A number of factors
can explain this: vastly differential levels of industrialisation, a lack of trade integration (currently about 25 per
cent of trade in the region is intra-ASEAN), differing political and legal systems, historic hostility between many
countries in the region and an unwillingness to cede power away from the nation state. ASEAN as an institution
is intergovernmental in nature and it is highly unlikely that a supranational system – such as that seen in the EU
– will develop in South East Asia. This is reflected in ASEAN’s small operational budget which in 2012 stands at
just over US$15m, and will only increase by 3 per cent in 2013.
ASEAN+3 leaders meet on the sidelines of ASEAN ministerial summits and a quasi-secretariat – the ASEAN+3
Macro Economic Research Office – was officially launched in Singapore in 2012. The major development
of 2012 has been the evolution of the ASEAN+3 grouping into a potential East Asian trade bloc. However,
ASEAN+3 members disagree on their relationship with the United States and other regional players such as
Australia and New Zealand. China in particular is keen to ensure that ASEAN+3 is the premier regional body to
the exclusion of the involvement of the United States. This stance is backed to some extent by Malaysia (which,
paradoxically, is participating in the Trans-Pacific Partnership – or TPP – negotiations), but Japan, Singapore
and the Philippines favour a more international trade grouping, involving the United States, Australia and New
Zealand.
At the same time a parallel trade initiative, under the auspices of the Asia Pacific Economic Cooperation
(APEC), is seeing a select group of Asian and Pacific countries negotiate a free trade agreement. Although
more geographically disparate, the countries of the TPP negotiations are select and perhaps more likely to be
successful in negotiating a free trade area. The United States is particularly keen to see the TPP succeed, as it is
a forum through which they can maintain their influence in the region.
Trans-Pacific Partnership Regional Comprehensive
Economic Partnership
East Asia Trilateral
Australia
Brunei
Canada
Chile
Malaysia
Mexico
New Zealand
Peru
Singapore
United States
Vietnam
ASEAN (10 member states)
Australia
China
India
Japan
New Zealand
South Korea
China
Japan
Korea
Box 11 Trade agreement negotiation partners
38
ASIA
What happens next:
Competing trade agreements and a race to the finish
TPP negotiations are advanced and a tentative deadline
for their conclusion has been set for the APEC leaders
summit in Bali, Indonesia, in November 2013. It should
be noted that this is a tentative deadline – the TPP has in
the past had numerous deadlines which have not been
met – leaders are therefore cautious about committing to
a formal deadline. ASEAN+3 negotiations are even more
complex and involve a consolidation of existing ASEAN+1
agreements, the negotiation of a trilateral FTA between
China, Japan and Korea (which could potentially be
overshadowed by the South and East China Seas issue),
and a regional comprehensive economic partnership
between ASEAN and their regional partners in Asia.
These negotiations are yet to get off the ground, but are
scheduled to commence in early 2013.
The key political issue to be resolved centres around
the relative influence in the region of the United States
and China. Japan, also, has been active in pushing its
interest in ASEAN and the nationalist victory at the recent
general election will increase the status of ASEAN as a
“battleground” of competing interests and spheres of
influence of the bigger powers.
Viewpoint:
Sirpa H. Ikola, Board Member, European
Chamber of Commerce Singapore
The promise of a single market of 600 million people
by 2015 has evoked the interest of many of the world’s
economic powerhouses. It seems that both the US and
China are competing for the attention and influence
of ASEAN, but so is Russia, Japan and the European
Union. The expectation is that ASEAN remains neutral
and united within their group. Is this possible?
Viewpoint:
Hugh Vanijprabha, Executive Director, Thai-
European Business Association
The first priority of ASEAN is to create one community.
Achieving a critical mass of acceptance of this concept
of one community amongst the people of ASEAN is the
key milestone. Education, both on and off campus, plays
a significant role to promote awareness and at the same
time, harmony amongst the people of ASEAN. The next
step is to then how combined strengths can be harvested.
Viewpoint:
Brigitte Holtschneider, Executive Director,
British Chamber of Commerce, Singapore
The overarching key challenge for ASEAN will
be to prove it can operate as a real economic
union and be the often cited market of about
600 million people in South East Asia. Prosperity
and development divides between the member
states are still rather significant which may keep
protectionist tendencies longer than helpful for the
common goal. The postponement of the Single
Window 2015 to the end of 2015 is testament
to this. Another key challenge in my view is the
successful integration of Myanmar. Respect
for Human Rights and political freedom is least
developed in this country and dealing with it as a
union is going to be critical for success.
Viewpoint:
Kuek Yu-Chuang, Board Director, Asia
Internet Coalition
Cross-border data flows are the new trade routes
for Asia and beyond. Asia’s future success will
hinge on the ability of individual economies to keep
these trade routes open and free. Artificial barriers
that impede data flows would greatly stymie
growth in the region.
Viewpoint:
Vikas Sharma, Principal Consultant, Frost
China has become an indispensable partner for the
ASEAN. For three years running, China has been
the largest trading partner for the ASEAN bloc,
with bilateral volumes topping USD $200bn a year.
Chinese companies looking for regional growth are
investing heavily in ASEAN nations and China has
offered financial support to ASEAN through funding
and preferential credits to support infrastructure
projects. Even in the USD $240bn strong regional
financial safety net, CMIM, China is the joint-largest
contributor. The Xi administration will use this
position of strength to persuade ASEAN nations
not to join Washington’s alleged China containment
policies and to strengthen its credentials as the
region’s pre-eminent geopolitical power.
ASIA
39
CHINA’S LEADERSHIP: A NEW GENERATION
TO SHAPE THE NEXT DECADE
The issue:
Challenges ahead for China’s new leadership
For the first time in a decade China has ushered in a
new cadre of leaders. A smaller than usual cohort of
seven men will lead China for the next decade. The
process of leadership renewal began years ago but it
was in November that the world got a glimpse of the
next generation of Chinese Communist Party leaders.
These Party leaders will take over the leadership of
state functions in March 2013.
Although conservatives – supported by former leader
Jiang Zemin – dominate the leadership, both Xi Jinping
(the next President) and Li Keqiang (the next Premier)
are likely to pursue warm relations with the West and
the United States in particular.
The real issue at stake though is whether China’s
economic reforms can remain on track – Xi Jinping is
less economic reform minded than his predecessor
Hu Jintao and whilst the Chinese economy is
comparatively strong, key challenges lie ahead, in
particular dealing with China’s demographic situation
and supporting an increasingly ageing population.
These challenges are not unique to China – Japan,
Singapore and many countries in the West are having
to deal with such challenges – but the danger is that
China’s population will age before it becomes a truly
rich country.
40
ASIA
China is not immune to the global economic downturn. The country’s post-crisis fiscal stimulus is unsustainable
in the long run and the new leadership is likely to focus on economic rebalancing away from export and
investment-led growth in favour of greater domestic consumption. The World Bankviii
has recently revised down
its 2012 growth forecast for China from 8.2 per cent to 7.7 per cent. According to the World Bank’s East Asia and
Pacific Data Monitor for October 2012, the growth downgrade is in part due to a fall in investment demand – in
2011 consumption demand contributed more to GDP growth than investment demand for the first time since
records began. The report states that “Some observers see this as the start of a trend in domestic rebalancing,
and associate this with a more permanent growth slowdown in China”.
How we got here:
Careful planning!
The leadership changes announced in November concern the leadership of the Communist Party of China,
which has been in power since 1949. At a meeting of the National Congress of the Communist Party of China
a new generation of leaders were anointed. However it won’t be until 2013 that the new leaders will take over
leadership of the State at the annual meeting of the National People’s Congress in March.
Held once every five years, National Congress of the Communist Party of China (CPC) is the leading body of the
Party. A central committee with approximately 350 members and alternates is elected at the National Congress
to carry out the party executive’s decisions, from this committee a group of leaders are selected to form the
politburo, which will eventually become the State Council – China’s equivalent of a cabinet – at the annual
National People’s Congress in March.
Leadership changes in China are planned and, at face value, stable. There is less traditional “political risk”
as China is not subject to the same levels of uncertainty thrown up by democratic elections. However, not
everything goes as planned and as the Communist Party and organs of the state are vast, a key challenge for the
leadership will be to maintain loyalty to the Party (and therefore government) and exercise sufficient control to
root out corruption.
What happens next:
Guarded reform
The politburo will take over the leadership of the Chinese state at the National People’s Congress in
March. While much of the agenda of China’s new leaders is known, the NPC will be an opportunity for more
detailed announcements on the future direction of China’s economic and industrial policy.
The anti-corruption drive is likely to dominate the domestic agenda and many in China are beginning to
question the actions and behaviour of local officials and leaders. The scandal of Bo Xilai’s wife poisoning British
businessman Neil Heywood was a rare public exposure of the excesses of some of China’s leadership. There
is a growing sense of unease that some at the top can act outside the boundaries of the law. Xi Jinping has
made clear that at the top of his agenda will be eradicating corruption. In an article for China’s People’s Daily,
he encouraged party members to “be brave in conducting criticism and self-criticism, take the lead to spread a
healthy spirit, and reject unhealthy trends and evil influences”
The second domestic issue that the new leadership will have to grapple with when it formally assumes office in
early 2013 is to continue with a restructuring of the Chinese economy. The US National Intelligence Council in its
latest “Global Trends” assessment states that China is likely to surpass the US as the world’s largest economy
by 2030. However, it also warns that significant challenges lie ahead. These include the effects of China’s one
child policy, which has led to a significant gender imbalance (which, in turn, could lead to social unrest), a rapidly
ageing population and rising inequality.
ASIA
41
Box 12
Source: United Nations
ix
0
2060204020202015201020052000198019601950 2080 2100
10
20
30
40
50
60
Age(years)/Dependancyratio
Demographic Trends in China
Year
Old age
dependency
ratio
Median Age
Although China still has an enviable growth rate, there is a need for China to reduce its reliance on government
investment and export-led growth. Domestic consumption has to rise as a proportion of GDP and this requires
a more equitable distribution of the proceeds of economic growth and a move to higher value-add production.
These challenges require economic restructuring and a dismantling of China’s state-owned enterprises. This
will be no easy task as SOEs are some of the most entrenched interest groups in the country; they have been
the conduit through which the Chinese government has stimulated the economy to insulate it from the global
economic crisis, and they are a training group for many of China’s most influential officials.
The State Council has asked policymakers and academics in China to draw up an ambitious economic and
structural reform plan over the next few months. In addition to reforming China’s SOEs are likely to be policies to
reform:
•	 China’s fiscal structure – likely to be simplified, and more localised. Currently central government collects
most of the tax revenues but local authorities are responsible for spending. This has led to a serious fiscal
disconnect and dealing with China’s local government debt is a key priority;
•	 Increasing the convertibility of the yuan;
•	 Reforming the interest rate system so that the market determines the cost of bank credit;
•	 Further opening up the price of land and natural resources to market forces.
These are just some of the main economic challenges China faces in the years to come and the first opportunity
to formally hear the new leadership’s economic priorities will be at the National People’s Congress in March.
42
ASIA
Viewpoint:
Vikas Sharma, Principal Consultant, Frost &
Sullivan Asia Pacific
The Xi administration needs to relook at the
exports-oriented development model that has
fuelled China’s rise as an economic superpower.
As demand from key export markets like the
US and the EU seems likely to remain anemic
in the foreseeable future, boosting domestic
consumption would need to be prioritized.
Viewpoint:
John Greenwood, Chief Economist, Invesco
In China, the new leaders should re-orientate
economy away from the export-led model. But
this is very difficult to do. For 30 years they
have been building an export-oriented economy
and a lot of government programmes provide
subsidies, benefits, tax incentives for investment
and exports. The huge investments in ports,
rail, and factories is all export orientated. But
domestic infrastructure (e.g. hospitals, shopping
malls, housing, particularly in the interior) have
lagged far behind. There is a major requirement
to rebalance things. But the problem is that the
easiest thing is to grow exports- the plants are
there to re-absorb the unemployed.
Viewpoint:
Anne Richards, Chief Investment Officer,
Aberdeen Asset Management
Xi hasn’t come in with a mandate to change; he’s
come in because the establishment think he will
continue to support current policies.
ASIA
43
Iran/Israel
One of the biggest threats to
global security is the Iran/Israel
issue. With 35 per cent of sea-
traded oil flowing through the
Strait of Hormuz, the world
could suffer a major oil price
shock should tensions between
the two countries escalate and
Iran blockades the Strait. Israeli
leader Benjamin Netanyahu
is particularly bullish and in
November told Israel’s Channel
2 “As long as I am prime
minister, Iran will not have the
atomic bomb… Israel is ready to
act”.
Asian Bond Markets Initiative
The ABMI is one of the single
biggest regional financial
services initiatives in Asia. The
fixed income market needs
to be developed, especially if
Asia’s infrastructure needs are
to be sustainably financed. The
ABMI is one of many initiatives,
but leaders will be hoping for
tangible progress in 2013.
ASEAN Economic Community
ASEAN leaders have set a
deadline of the end of 2015 for
the completion of the AEC. This
is ambitious and unlikely to be
achieved, but with eighteen
months to go, Brunei, the
ASEAN chair for 2013, will be
hoping to make up lost ground
under Cambodia’s chairmanship
in 2012. Of particular interest to
the banking sector is the recent
announcement of a Qualified
ASEAN Bank Scheme, whereby
regional banks will be given
an ASEAN “passport” to offer
services across South East Asia.
As with most ASEAN initiatives,
the plans are ambiguous and
lack detail.
North Korea
Pyongyang launched a long-
range rocket at the beginning of
December, another milestone in
North Korea’s nuclear capability
ambitions. The US and Japan
have expressed deep concerns,
but China, was more muted
in its response. Although a
historical ally of North Korea,
further posturing by Kim Jong
Un could lead to Beijing re-
appraising its approach.
Burma
Ethnic clashes, particularly in
Myanmar’s Arakan province,
threaten to overshadow the
reform process. Aung San Suu
Kyi has warned about the risk of
a “mirage of success”.
ON THE AGENDA –
THINGS THAT WILL DRIVE THE DISCUSSION
IN 2013
44
Footnotes
http://www.newyorkfed.org/research/national_economy/householdcredit/DistrictReport_Q32012.pdf
Guardian/ICM Poll, 20 November 2012, http://www.icmresearch.com/guardian-poll-november-2012.
Ibid.
Allister Heath, Business needs to engage in shaping Britain’s post-EU future, The Telegraph, November 2012
Office of National Statistics, March 2012, Balance of Payments, 4th Quarter and Annual 2011 Dataset, http://www.
ons.gov.uk/ons/rel/bop/balance-of-payments/4th-quarter-and-annual-2011/tsd-bop-time-series.html
Ipsos MORI, November 2012, Public divided on our future with the European Union, http://www.ipsos-mori.com/
researchpublications/researcharchive/3075/Ipsos-MORI-Political-Monitor-November-2012.aspx
http://www.eia.gov/oiaf/aeo/tablebrowser/#release=IEO2011&subject=0-IEO2011&table=1-IEO2011&region=0-
0&cases=Reference-0504a_1630
http://www.worldbank.org/content/dam/Worldbank/document/EAP-Data-Monitor-October-2012.pdf
United Nations http://esa.un.org/unpd/wpp/country-profiles/pdf/156.pdf. The dependency ratio is the ratio of the
population aged 65 years or over to the population aged 20-64.
i
ii
iii
iv
v
vi
vii
viii
ix
USA
45
Appendix
Panel of experts:
John Greenwood, Chief Economist, Invesco
Brigitte Holtschneider, Executive Director, British Chamber of Commerce, Singapore
Sirpa H. Ikola, Board Member, European Chamber of Commerce Singapore
Stephen King, Chief Economist, HSBC
Karel Lannoo, Director, Centre for European Policy Studies
Will McBride, Chief Economist, Tax Foundation
Patrick Nolan, Chief Economist, Reform
Jason Peuquet, Research Director, Committee for a Responsible Federal Budget
Anne Richards, Chief Investment Officer, Aberdeen Asset Management
Vikas Sharma, Principal Consultant, Frost & Sullivan Asia Pacific
Garich Lim Shington, Director, Seaward Chemicals
Hugh Vanijprabha, Executive Director, Thai-European Business Association
Holger Wessling, General Manager, DZ Bank AG
Bob Williams, President, State Budget Solutions
Kuek Yu-Chuang, Board Director, Asia Internet Coalition
Additionally, a number of industry representatives contributed off the record comments, having asked to remain
anonymous.
46
About Cicero
Cicero Group is an international consultancy specialising in corporate communications, digital strategy,
government affairs, political risk and thought leadership generation for policy, business and consumer
audiences.
For more information please contact:
John Rowland
Senior Country Officer
Tel: +1 202 280 6373
Email: John.Rowland@cicero-group.com
Iain Anderson
Director and Chief Corporate Counsel
Tel: +44 (0)20 7665 9532
Email: Iain.Anderson@cicero-group.com
www.cicero-group.com
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Continental Drift - An analysis of global political risk (2012)

  • 1. CONTINENTAL DRIFT AN ANALYSIS OF GLOBAL POLITICAL RISK DECEMBER 2012
  • 2. 2 Political risk is something typically associated with poor, unstable nations. Those countries, usually hot ones, where the deals get done in hotel lobbies by men with firm handshakes and an armoured four wheel drive. But this view is mistaken; the impacts of government decision makers pervade commercial life in developed countries too. Nowhere has this been more readily demonstrated than by the mature democracies of the North Atlantic as they flounder in the aftermath of the financial crisis. This report takes as its central tenet the idea that, wherever you are deploying capital, there is no room for complacency about political risk. Our teams in London, Brussels, Washington and Singapore have picked the key developments that they think could shape the political economy of their regions in 2013. Areas where we do not have regional offices, namely the Middle East and Latin America, have not been covered. In addition, we have interviewed a range of commentators and market participants to get their views on the year ahead. You will see their analysis in the Viewpoint boxes throughout the report. The result is a rich smorgasbord of fact, opinion and crystal ball gazing. This is not an enterprise with scientific pretensions nor is it exhaustive. Rather, the main purpose of this analysis is to provoke discussion and debate about the year ahead. John Rowland Senior Country Officer Cicero Group INTRODUCTION
  • 3. 3 CONTINENTAL DRIFT Many of the risks in the year ahead could be the result of what might be characterised as drift. This applies in two senses: First, a lack of leadership and political will that leaves nations and regions without a clear strategy to solve serious long-term challenges. And second, in the sense of drifting apart through a divergence of interests over time. In the United States all eyes are on the fiscal cliff kabuki. It looks like a deal is in the offing that could see Republicans u-turn and accept tax rises. For all of the fuss, the fiscal cliff negotiation is merely Washington digging out of a hole it created for itself. But the long-term challenges of reforming entitlements and tax codes will not be settled by the cliff and are much more complex. Will President Obama and Speaker Boehner turn their attentions to this in the New Year? Or will the deal leave the prospects of a long-term deal in tatters? A lack of action here will leave the US drifting towards a genuine fiscal crisis. The United Kingdom is drifting apart from the EU. As the eurozone prepares to chart a more integrationist course, a referendum could ask the British people for their views on future relations with the EU. But is there a credible strategy for life outside of the EU? Or will the UK stay inside as a semi-detached member? Without a well formed plan, British business will suffer from the uncertainty. Without imminent calamity in the European Union to focus minds on reform, and with forthcoming elections in Italy and Germany, could we see leaders put essential structural changes to the Economic and Monetary Union on the backburner? Is it possible that, ironically, the relative calm in markets leaves the bloc drifting towards another crisis? We also picked out the EU drifting towards protectionism as a risk – though we could easily have argued the same about the US in its attempts to apply financial regulation extra-territorially. We will come back to the issue in a future report. Cicero contributors Editor: John Rowland UK: Daniel Wright, Cameron Rae, Georgina Rawkins EU: Saana Kyröläinen, Tim Gieles US: John Rowland, Peter Benton Sullivan Asia: Andrew Naylor Panel of experts: for a full list of all external contributors, please see appendix (p45) Each of the experts gave their opinions. Their participation does not infer endorsement or agreement with any other content in the report Finally, could the slow escalation of a regional stand- off over shipping lanes and resources in the Asia Pacific region cause countries around the South and East China Sea to drift into open conflict? In a region that has driven the global economy, such a confrontation is a very worrying prospect. These are just some of the things that we think could shape 2013. We hope you enjoy reading it.
  • 4. 4 CONTENTS POLITICAL TIMELINE 5 ABOUT CICERO 46 2013 UNITED STATES OF AMERICA 6 THE FEDERAL BUDGET: STUCK BETWEEN A CLIFF AND A HARD PLACE STATE BUDGETS: UNITED IN PAIN STUDENT LOANS: NOT MAKING THE GRADE SHALE ENERGY: AMERICA’S GET OUT OF JAIL FREE CARD ON THE AGENDA – THINGS THAT WILL DRIVE THE DISCUSSION IN 2013 UNITED KINGDOM 15 THE COALITION: CAN THEY GO THE DISTANCE? THE CUTS: AT WHAT COST? UK AND THE EU: DRIFTING APART? ON THE AGENDA – THINGS THAT WILL DRIVE THE DISCUSSION IN 2013 EUROPEAN UNION 24 EUROZONE: WHEN THE FIRE IS OUT, WILL LEADERS SEE THROUGH THE SMOKE? NATIONAL ELECTIONS THAT COULD CHANGE THE COURSE OF THE EUROZONE A PROTECTIONIST SHIFT ON THE AGENDA – THINGS THAT WILL DRIVE THE DISCUSSION IN 2013 ASIA PACIFIC 33 MARITIME DISPUTES: MAKING WAVES IN ASIA AN ASEAN-CENTRIC ASIA? CHINA’S LEADERSHIP: A NEW GENERATION TO SHAPE THE NEXT DECADE ON THE AGENDA – THINGS THAT WILL DRIVE THE DISCUSSION IN 2013
  • 5. JANUARY Israel General election 23-27 JANUARY World Economic Forum Annual Meeting Davos, Switzerland FEBRUARY (tbc) Italy General election 2013 2014 JanuaryFebruary March April AugustSeptember May July November December June MARCH (tbc) China National Peoples’ Congress and People’s Po- litical Consultative Conference Beijing 2-5 MAY ASEAN+3 Finance Ministers and Central Bank Governors Meeting New Delhi 19-20 APRIL Spring meetings of the World Bank and International Monetary Fund Washington DC To be held by: 1 NOVEMBER Australia General election 13-14 JUNE G8 Summit UK SEPTEMBER G20 leaders’ Summit St Petersburg, Russia SEPTEMBER Austria General election OCTOBER APEC Leaders Summit Bali, Indonesia OCTOBER Annual meetings of the World Bank and International Monetary Fund Washington D.C. General election Key events POLITICAL TIMELINE October 1 SEPTEMBER - 27 OCTOBER Germany General election NOVEMBER (tbc) ASEAN Heads of Government Meeting and East Asia Summit Brunei 2-5 MAY Asian Development Bank Annual Meeting New Delhi 30 MARCH The 5th BRICS Summit South Africa 5-7 JUNE World Economic Forum on East Asia Myanmar 27 JUNE Malaysia General election JUNE Iran General election
  • 6. 6 UNITED STATES OF AMERICA THE FEDERAL BUDGET: STUCK BETWEEN A CLIFF AND A HARD PLACE The issue: After fiscal cliff negotiation is concluded, America’s leaders fail to chart credible path to long-term fiscal sustainability As this report went to press, bipartisan negotiations were underway to avert what has become known as the ‘fiscal cliff’, a mix of automatic tax rises and spending cuts due to hit simultaneously on Jan 1 2013. US experts interviewed by Cicero Group for this report agreed that the aftermath of the fiscal cliff was the most important political risk in 2013. Going over the cliff would take care of the deficit in short order. But the economic shock would cause a recession in early 2013. The alternative, doing a deal to avert the cliff, would prevent the ignominy of a recession with ‘Made in Washington’ stamped all over it. But it would also leave the US drifting towards a debt crisis. (See box 1). However, the fiscal cliff will not address the key long-term challenges facing the US, namely reform of entitlements and the tax code. This will require much tougher choices to be made about the size and role of government than those presented by the fiscal cliff negotiations. The danger is that the fallout of the fiscal cliff poisons the chances of reaching a credible deal, strangling future economic growth and scaring debt markets in the longer term. Alternatively, the deal may allow politicians the breathing space to turn attentions to other matters and punt on the reforms needed to guarantee the long-term fiscal health of the country. Viewpoint: Senior Wall Street government relations professional I’m optimistic that Congress and the President will achieve an agreement on the fiscal cliff by year end. That said, I think the chances of a meaningful long-term deal on entitlements and revenues are less than 50 per cent. Sure, there will be some revenue increases and spending cuts, but the election didn’t suspend the laws of political gravity and it won’t take long for the intense partisanship to dominate the discussions such that a meaningful deal will be difficult to achieve.
  • 7. USA 7 Estimated ownership of US Treasury Securities as of March 2012 Source: US Treasury The US government is its own biggest single creditor, largely due to the holdings of the Social Security Trust Fund. However, most debt is held by the public. The largest class of public investor is foreigners (including overseas governments) with more than $5tn in holdings. Public investors perceive treasuries as safe assets issued by a creditworthy government. However, rating agencies and bond markets will become nervous if sustainable fiscal reform is not forthcoming. Box 2 Uncle Sam’s creditors US Savings Bonds, 185 Depositary Institutions and Insurance Companies, 561 State and local governments inc. pension funds, 625 Other investors, 1230 Mutual funds and private pension funds, 1450 Foreign and international investors, 5135 Federal Reserve and Intergovernmental holdings, 6397 0% 25% 50% 75% 100% As a result of previous failures to come to a bipartisan budget agreement, current law would see $500bn in defence cuts and more than $2.7tn in tax increases over ten years from Jan 1 2013. This fiscal sledge hammer would put debt on a downward slope, but at the cost of serious economic dislocation. On the other hand, ‘Realistic Baseline’ projections by the Committee for a Responsible Federal Budget suggest that a deal to avert the fiscal cliff – which might see taxes go up on the rich and much smaller spending cuts – would nevertheless lead to huge increases in debt in the longer term. It is worth noting that these percentages do not include debt held by the government. As such the ratio of gross debt to GDP is considerably higher than these charts suggest. The OMB estimates a gross debt ratio of 105 per cent by the end of 2012. Box 1 Fiscal cliff vs deal – the implications for US national debt 2000 2010 2020 2030 2040 2050 0 50 100 150 200 Debt projections (debt held by public as percentage of GDP) Source: Committee for a Responsible Federal Budget CFRB ‘Realistic Baseline’ CBO Current Law Per cent Year USD,billions
  • 8. 8 USA What happens next: What happens next: beyond the ‘fiscal cliff’ – drift or action? Neither outcome to the fiscal cliff negotiation is optimal. But the experts we asked agreed that the best outcome is a short-term deal now, followed by a serious effort to achieve a long-term bipartisan deal in 2013. The first part looks likely to happen. The second part will be much harder to reach agreement on. What would a long-term deal have to address? First, a way to arrest the annual growth rate of the costs of Medicare and Medicaid, currently at 6.3 per cent and 8.1 per cent respectively. Secondly, an overhaul of the labyrinthine tax code, ideally including modernisation of the uncompetitive corporate tax system. Dusting off the Simpson-Bowles proposals may not be a bad place to start. The risk is that the opportunity to set out a new path in 2013 is squandered. If that comes to pass, the implications will be far-reaching. Where will the money be found to fund the renewal of America’s creaking infrastructure? Will America be able to preserve its military pre-eminence? And what of the public school system, which underperforms woefully for a country of America’s wealth? The pressure is therefore on President Obama and Congress to think long-term in 2013. If they do, it would send a signal to the public, business and creditors that America’s leaders are more interested in governing than partisan manoeuvring. But endlessly kicking the can down the road will saddle the country with debt, erode its competitiveness and eat away at the credibility of the US system of government. How we got here: Partisan rancour brings US to cliff-edge The US Treasury has financed two major wars and a huge bailout package over the last decade. Spending on entitlements, such as the popular Medicare programme, is increasing as the population ages. Meanwhile, on the revenue side, costly temporary tax cuts introduced by George W Bush have been extended. Growth continues to be weak, depressing tax receipts. A complicated tax code full of allowances, deductions and loopholes is economically inefficient and costly to administer. Democrats and Republicans agree that the situation is not sustainable, but they have not been able to agree on what to do about it. Attempts to come to a comprehensive, bipartisan deal, such as the 2010 Simpson-Bowles Commission, ended without agreement. This is because Republicans have refused any deal that involves tax increases, wanting instead to see sharp cuts in spending and further tax cuts. Democrats on the other hand have insisted on increased taxes – particularly on the rich – and smaller cuts to spending. As a secondary matter, the White House is now also asking for powers to raise the debt ceiling without recourse to a Congressional vote, which the GOP opposes. Whether the gap can be bridged is at the heart of the fiscal cliff negotiations and thus, indirectly, whether a long-term budget deal can be reached at a later date. “Medicare and other healthcare spending will nearly double in the next 35 years as a share of the economy, approaching the amount we currently spend on everything else outside of Social Security. Taxes as a share of the economy will have to rise to a level never before seen in the US in order to pay for that increased spending” Scott Winship, Brookings Institution
  • 9. USA 9 Viewpoint: Ike Brannon, Director of Economic Policy, American Action Forum The resolution of the fiscal cliff will determine whether Congress and the Administration can work together to complete a fundamental reform of the tax code and the entitlement problem in 2013. The President has the ability to press the Republicans into taking a tax rate increase and could walk away from that declaring victory. But such a victory would be a hollow one at best. Making Republicans walk the political plank would poison future negotiations between the two parties, making tax reform – or any other major bipartisan legislation – nearly impossible. If the President wants a second-term legacy, addressing the corrupt, antiquated tax code and entitlement system would be a good start. If it’s done by a President Hillary Clinton or a President Chris Christie, the punt will be a blot on Obama’s legacy. If he manages to create a constructive working relationship with Republicans during his last four years in office, that alone would be an accomplishment. Here’s betting that he gives the Republicans a chance to save face and keep them from having to vote for higher tax rates. Viewpoint: Jason Peuquet, Research Director, Committee for a Responsible Federal Budget At this point, it is clear that doing nothing to control deficit and debt down the road is simply not an option. The fiscal cliff is an opportunity to put in place the beginnings of a smart and gradual deficit reduction package. We’re hopeful that elected leaders can set the stage for entitlement reforms and tax reforms to be worked out early next year to ultimately put the debt on a downward path as a share of the economy. Viewpoint: Senior Wall Street government relations professional I think the US political system is close to a crisis point. In my several decades in Washington, I’ve never seen the interests of the public and the parties so divergent: while today the American public – not to mention American business – fervently want the parties to work together to address problems, the parties meanwhile are focused on satisfying their bases. Either some exogenous force occurs to break the gridlock, or Washington will become ever more extraneous to the rest of the nation.
  • 10. 10 USA STATE BUDGETS: UNITED IN PAIN The issue: State governments are facing budget crises It is not just the federal government that has a budget problem. State Budget Solutions, an advocacy group, calculates that aggregate debt across the 50 states was nearly $4.2tn in 2012. The largest debts are held by California ($618bn) and New York ($300bn). How we got here: The cost of pensions is crippling some states Market-valued unfunded public pension liabilities now make up more than half of all state debt. Illinois state and local pension debt is now one-third of its gross product. Municipalities are also being dragged down by pension liabilities. San Bernadino in California stopped making contributions to the state employees’ pension fund, after filing for bankruptcy in October 2012. What happens next: Without reform, cuts to services inevitable The aftermath of Sandy demonstrated just how big a role states have in providing the services and infrastructure citizens rely on. Hardening key infrastructure against extreme weather should be a major priority for state governments. This would provide an economic stimulus to the construction industry, helping spur the economy. But the kind of capital intensive, long-term investment required will be hampered if state budgets are in a mess. We asked two experts for their views on state finances in 2013. They warned that in the outlook was grim for many states, with cutbacks in services, lay-offs and even capital flight in prospect. Viewpoint: Bob Williams, President, State Budget Solutions If governors and legislators continue to fail to understand the scope of the pension crisis and delay action, it will set taxpayers up for a much bigger catastrophe in the future. Failing to make meaningful reforms to pensions now will result in future cuts to essential public services – public health, safety and education – and dedicated government workers being laid off. It is vital to reform public pensions now. Real reform must be based on actual numbers instead of optimistic outlooks based on unrealistic assumptions. Viewpoint: Will McBride, Chief Economist, Tax Foundation Certain states are going over their own voter- induced fiscal cliff, particularly California and to a lesser degree Illinois. This will result in flights of capital and labour from those states. I expect to see more municipal bankruptcies in 2013.
  • 11. USA 11 STUDENT LOANS: NOT MAKING THE GRADE The issue: Serious delinquencies are on the march While the US economy is still slowly recovering from the subprime mortgage crisis, another debt bubble may be lurking. A recent New York Federal Reserve report on household debt and credit showed that the fastest growing sector in US consumer debt is student loans i . According to the New York Fed, outstanding federal student loan balances increased to $956bn dollars at the end of Q3 2012, an increase of $42bn for the third quarter alone. Worryingly, the delinquency rate for student loan balances has increased substantially this year, despite changes made to the rules to ease repayment terms in 2011. The percentage of student loans that have been delinquent for 90 days or more has risen from 9 per cent to 11 per cent. It has now overtaken credit cards to become the most delinquent form of credit. (See Box 3). Box 3 03:Q1 07:Q104:Q1 08:Q105:Q1 09:Q106:Q1 10:Q1 11:Q1 12:Q1 Source: Federal Reserve Bank of New York Credit Card Student Loan Mortgage HE Revolving Auto 0 3 6 9 12 15 Percentage of loans 90 days or more delinquent, by quarter Percent Year (20XX):Quarter
  • 12. 12 USA How we got here: Attending college – the other American Dream A university education was once reserved for a wealthy few who went on into a select range of professions. That has changed over recent decades. On the supply side, higher education has become more accessible due to the wide availability of loans and financial support. On the demand side, a college degree has become a requirement for an ever wider range of jobs. These dynamics have driven a surge in the cost of tuition. But with the economic slowdown, there are more unemployed or underemployed graduates carrying a heavy burden of student debt. What happens next: A bubble about to burst? This is a huge but surprisingly poorly understood credit market. Unlike mortgage credit, student debt is not dischargeable in a US bankruptcy court. On an individual level this means borrowers are forced to deal with the long-term consequences of having a bad debt on their credit record. This affects their ability to fund large purchases such as cars and homes. At a macro level, the federal government is by some margin the largest provider of student loans. This opens the possibility that the government has to use taxpayer dollars to carry increased credit risk on the student loan book. Keep watching those delinquency rates in 2013. “With college enrolments increasing and the costs of attendance rising, this balance is expected to continue its upward trend. Further, unlike other types of household debt such as credit cards and auto loans, the student loan market is incredibly complex.” Federal Reserve Bank of New York
  • 13. USA 13 SHALE ENERGY: AMERICA’S GET OUT OF JAIL FREE CARD The issue: Shale gas – a potential game changer Geopolitical uncertainty in Africa and the Middle East and competition for resources from new world powers like China are worries for strategists in Washington. America’s thirst for foreign crude oil – of which it is the world’s largest importer – means that its economy is highly exposed to volatility in global oil prices. But technological developments in drilling mean that the US is on the verge of an energy revolution. The US may have such vast deposits of shale gas and oil that it could be completely energy independent by 2035, and become one of the world’s largest exporters of liquefied natural gas. How we got here: Vast discoveries of shale gas deposits across continental US A drilling technology called hydraulic fracturing, or ‘fracking’, has allowed energy producers to drill for natural gas in shale deposits that were previously inaccessible. Fracking has become one of the fastest growing industries in the US, centred on areas where there are large gas fields such as North Dakota and Appalachian Mountain states like Pennsylvania. What happens next: Drill baby, drill? The shale boom will not be big enough to offset the cost of inaction on the federal budget. But it could be a new cornerstone for America’s economy. It will also fundamentally alter the global energy market. Saudi Arabia is already lowering its crude production in response while Europe may one day be able to import natural gas from the US instead of Russia. However, the extent to which this happens depends on whether political leadership is willing to fully embrace this controversial drilling method. The domestic energy industry is rarely far from political conflict. The Gulf oil spill and the controversy over the construction of the mammoth Keystone XL pipeline show the difficulties of balancing economic growth against potential environmental damage. President Obama has supported the effort somewhat as part of his ‘all of the above’ approach to energy. But fracking is strongly opposed by environmental groups – and many in his own party – who believe that the process can poison groundwater and release high levels of greenhouse gases. This sets the stage for a battle between those who see a huge economic stimulus in shale energy, and those who see profiteering at the cost of the environment. This battle has already started to play out in Pennsylvania, which now allows drilling, and New York, where it is currently banned. “Shale gas is expected to support one and a half million jobs, and contribute nearly $200bn to GDP by 2015. By 2035, those numbers are expected to double.” Speech by Jack Williams, President, XTO Energy
  • 14. 14 USA Where next for the GOP? While its electoral coalition tends to serve it well in the House, Mitt Romney’s dominance in the white male demographic was not enough to get him elected. The party will need to reach out to growing populations – such as Latinos – to take back the White House. But this will require a policy rethink which may not go down well with the party faithful. Supreme Court The President will be in a position to appoint at least one judge in his second term. The Court has made decisions on several major areas of public policy in recent years including campaign finance and healthcare. It is set to hear a significant case challenging affirmative action in the New Year. The ability to appoint a liberal justice will be one of his main legacies. Dodd-Frank The implementation of this mammoth reform of financial regulation rolls on. Rulemakings will continue to reshape the US finance industry, making the country less welcoming to foreign institutions and cutting the profitability of domestic ones. Whether the industry will be ‘safer’ remains to be seen. Duplicative regulation is a serious worry, as the US and EU fail to see eye-to-eye on mutual recognition of regulatory and supervisory structures. New faces Several key members of Obama’s administration are stepping down. These include Secretary of State Hillary Clinton and Treasury Secretary Timothy Geithner. Immigration reform Latinos are the fastest growing population in the US. Democrats are supportive of reform, which has attracted Latino voters to their ticket. Reforms could also permit more foreign high-skilled workers into the US which business groups such as the US Chamber of Commerce strongly support. ON THE AGENDA – THINGS THAT WILL DRIVE THE DISCUSSION IN 2013
  • 15. 15 UNITED KINGDOM THE COALITION: CAN THEY GO THE DISTANCE? The issue: Cracks emerging in relationship The coalition agreement between the centre-right Conservatives and the centre-left Liberal Democrats in 2010 was designed to last five years. After a torrid 2012, tensions between the two parties create a possibility that the coalition government could break up in 2013, or more likely in 2014, over irreconcilable differences on the economy and Europe. Viewpoint: Patrick Nolan, Chief Economist, Reform In the UK the key thing is public finances. There is probably going to be a spending review which will move forward from 2014 to 2013 and, of course, the election is coming up, so people are going to be thinking about manifestos. That means there is going to be a lot more debate around public finances, the impact of austerity on the economy, how that translates to spending plans and how parties should be positioning themselves prior to the election. How we got here: Gaps between parties getting harder to bridge The senior leaders of the coalition are known as ‘the quad’ (see box 4). They remain committed to the coalition and to its objective of deficit reduction. However, some of Liberal Democrat leader Nick Clegg’s flagship policies have been derailed by Conservative rebels, weakening him. As a result he is now willing to veto Conservative policies. Nevertheless the relationship in the quad remains constructive. But outside of it, the cracks are deepening. Within the Conservative party, old divisions on Europe are coming to the fore. One hundred of Cameron’s MPs are now willing to vote against the government on EU matters, removing the coalition’s majority at a stroke. This is in sharp contrast to the pro- Europeans on the Liberal Democrat benches. Meanwhile, Liberal Democrats fret about their dreadful poll numbers which they partly blame on their association with the Conservatives. An ICM poll released on 20 November had the party losing around half of their seats in the House of Commons ii . Some of the left-leaning party base, who had never bought into the government’s austerity agenda, would like to depose Mr Clegg and demand renegotiation of the coalition agreement or even complete withdrawal. David Cameron, Prime Minister (Con) George Osborne, Chancellor (Con) Danny Alexander, Chief Secratary to the Treasury (Lib Dem) Nick Clegg, Deputy Prime Minister (Lib Dem) Box 4 The Quad
  • 16. 16 UK What could happen next: Staying together for the children, or ugly divorce? There is no doubting that storm clouds are gathering over the coalition. The next 12 months have the potential to give malcontents on both sides plenty of fodder. Many of the deepest spending cuts are set to bite in 2013. Worse, the autumn statement revealed that the government is far off its deficit reduction targets, extending austerity to 2018. There are Liberal Democrats who wonder if it is better to get out now, rather than risk electoral annihilation in the future, as they become ever more deeply identified with austerity. Then there is the UK’s relationship with the EU, an issue on which the Conservative party has a history of internecine warfare and where the two parties share almost no common ground. The Liberal Democrats are worried about drifting away from Europe; many Conservatives would like nothing less. This issue will no doubt see more backbench rebellion and the erosion of the coalition’s voting majority. The Conservatives are also looking nervously at the UK Independence Party (UKIP), an anti-EU party who are polling nearly 10 per cent of the public vote, with support drawn mainly from jaded former Conservatives. What would happen if the coalition became untenable? One possibility is that the Conservatives would form a minority government, possibly negotiating a ‘confidence and supply’ agreement with the Liberal Democrats to help pass essential legislation such as the annual budget. Such an arrangement could be highly volatile and would be likely to unnerve business and markets which have tended to buy into the coalition’s stable commitment to deficit reduction. Box 5 Labour Liberal Democrats UKIP Other Conservatives YouGov/The Sun poll 4/12/12 Election Results May 2010 29% 23% 36% 3% 9% Latest Polls Dec 2012 44% 11% 30% 10% 5% 2010 election results vs latest polls
  • 17. UK 17 The second possibility is that an early election is called following a two-thirds vote in the House of Commons. Polling indicates that Ed Miliband’s Labour party would emerge as the largest party iii . Labour would attempt to slow down the deficit reduction process, though in general their policies are underdeveloped. If the transition was quick and the new government was considered credible by the markets, the impact of a change in government might only be fleeting. Are these likely outcomes? The commentators we spoke to said that the potential costs of torpedoing the coalition for both the Liberal Democrats and the Conservatives were too large. First, why create the possibility of an election when defeat for both parties is assured? Second, Cameron and Clegg have a great deal personally invested in this project and in many respects are more closely aligned with each other than they are to fringes of their own parties. It is more likely that the coalition will stay together over 2013, but by 2014’s European elections – where the Liberal Democrats will fare poorly nationally and UKIP may well come first – tensions may reach an untenable level causing an early coalition break-up. In the interim, the marriage is becoming a rockier one. So while 2013 might see the coalition try to hold it together, by 2014 it could end in a messy divorce. Viewpoint: Senior executive at leading business association The risk is that the actual deals being struck behind the scenes to ensure that the coalition actually works will be more difficult to make, especially with the pressure from the Tory right. Viewpoint: Anne Richards, Chief Investment Officer, Aberdeen Asset Management If they break-up and and an election was called, it is not clear that the Tories would win an outright majority. In the current prevailing mood I think the Lib Dems are in such a weakened position that the only thing they can do is cling onto the vestiges of power in the hope that they may be able to sway some vote- winning policy in their direction by 2015. Viewpoint: Stephen King, Chief Economist, HSBC I personally think a coalition breakup is unlikely; only because both parties have everything to lose by having an early election and little to gain. It is a strange marriage where everyone can see the disadvantages but at the same time it is better to stay together for the sake of the children.
  • 18. 18 UK How we got here: Monetary easing has failed to counterbalance austerity The response of the coalition government to Britain’s economic malaise has been to implement a programme of spending cuts and tax rises to reduce the deficit and maintain market confidence. To stimulate economic activity and offset the contractionary forces of austerity, the Bank of England has increased the supply of money in the economy through quantitative easing. But economic growth has not been forthcoming. Turbulence in the eurozone continues to hurt the UK economy. Weaker than forecast tax receipts mean that the Chancellor could miss his borrowing target by £13bn in 2012. The government’s autumn statement saw the announcement of below-inflation benefit increases in the coming years to help meet deficit reduction targets. Austerity is to be extended until 2018, far beyond the next general election. Meanwhile, the cost of living has continued to rise steadily, while wages have not kept pace. This has resulted in an extended squeeze on living standards for working families. UK official statistics show disposable incomes fell 4.3 per cent on average for the middle fifth of households – £1,100 per household between the financial years 09/10 and 10/11. At the same time that ordinary families are struggling, there is evidence that low social mobility is becoming problematic. Government adviser and former Labour minister, Alan Milburn, published a report in October 2012 stating that social mobility is ‘flatlining at best’ and could even be reversed unless educational opportunities are improved for poorer students. It’s only just begun? The Institute for Fiscal Studies has estimated that by the end of 2012, only 12 per cent of the government’s austerity measures will have been implemented. According to the recent Austerity Tracker Poll, 59 per cent of households believe they have not been impacted so far. 61 per cent said they expected to be hit by the cuts in 2013. Almost half (48 per cent) said they disagreed with the Government’s austerity programme. Viewpoint: Patrick Nolan, Chief Economist, Reform [Civil unrest] will certainly happen in the eurozone, but does that get imported into the UK? [There are] very different economic conditions of course, but certainly when you look at what countries like Greece and Spain are going through, I certainly think those issues are going to arise and you can see that by the share of votes that is going to relatively fringe parties. THE CUTS: AT WHAT COST? The issue: Does flat-lining economy + government spending cuts = year of discontent? Greece and Spain have seen widespread social unrest as a result of deep austerity. While the UK has not witnessed such scenes, the last couple of years have seen a marked increase in industrial action and organised protest against government policies. There were 1.4 million days lost to strikes in 2011, the highest number since 1990. The coming year will see the implementation of some of the government’s most severe cuts. Worse still, outgoing Bank of England Governor Mervyn King appeared to suggest in November that country is only half-way through a ‘lost decade’. Could that translate into similar unrest on the streets of Britain?
  • 19. UK 19 What could happen next: Full steam ahead, or change in course? Could a perceived lack of opportunity combined with a decline in living standards translate into increased civil unrest and extensive industrial action when the full effect of the cuts is felt in 2013? Unless there is economic growth to show for the pain of austerity – or least the prospect of it – the answer must be that it is a serious possibility. Increased unrest would lead to further economic headwinds for the economy, in the form of work days lost due to strike action and reduced consumer spending. It could discourage investment, depress house prices and increase unemployment. The country is currently divided over the austerity programme. One possible bright spot is that the UK’s economy is predicted to grow by 1.2 cent next year, more quickly than any of the major economies in the eurozone. This may vindicate the Chancellor and put him in a position to argue for continuation of the austerity plan. But if there is no growth, the Chancellor’s strategy will likely cause widespread discontent and a new approach may be required. The departure of the Bank of England’s Mervyn King, an architect of the strategy, may be an opportunity for this change. Osborne himself will be under increased pressure in 2013. Though his recent autumn statement was received far better than his previous budget, the UK remains on a negative ratings outlook from all major credit rating agencies. The Chancellor will have to deliver a convincing set of measures this spring in order to guarantee his job through to the next election. Estimated and projected UK GDP growthBox 6 Estimated and projected UK GDP growth Source: HM Treasury -0.5 2011 2012 2013 2014 2015 2016 2017 1.0 0.5 1.0 1.5 2.0 2.5 3.0 Per cent 0.9% -0.1% 1.2% 2.0% 2.3% 2.%7 2.8% Year Viewpoint: Stephen King, Chief Economist HSBC A lot of the cuts will materialise more forcibly over the next year or two and that’s when things will begin to bite...The problem here is not so much the cuts in isolation, but that there is no recovery because the whole idea originally is that you aim fiscal policy at delivering austerity and you aim monetary policy at delivering a recovery and activity. The main surprise over the last year or two isn’t the intensity of the fiscal policy but rather the impotence of the monetary policy.
  • 20. 20 UK “We always have to do something that will stand up to public opinion back home...Despite differences that we have, it is very important for me that the UK and Germany work together” Angela Merkel makes common cause with David Cameron on the EU budget in November 2012 UK AND THE EU: DRIFTING APART? The issue: As eurozone integrates further, Brixit from EU increasingly a possibility While the ongoing eurozone crisis has drawn its members towards closer political and economic integration, the UK is increasingly an outsider. The tone of public debate in Britain has become increasingly eurosceptic and a referendum on the UK’s relationship with the EU could be announced in 2013. Many Conservatives have long dreamt of a repatriation of EU powers, with many Tory backbenchers preferring outright withdrawal from the union. With public discontent towards Europe growing, these eurosceptics sense that their moment has arrived. If the UK powers ahead with plans for a referendum on the issue, it risks drifting away from the continent and losing its place at the EU table. How we got here: The rising tide of euroscepticism in the UK Economic dislocation in the eurozone has strengthened the voices of those who want the UK to reassess its relationship with the EU. Notably among them are a cadre of rebellious and vocal Tory backbenchers elected in 2010. They are disenchanted by the political dynamics of the Con-Lib coalition and are becoming increasingly restive. For his part, David Cameron’s line on Europe is deliberately ambiguous. He knows how important the single market is for British business, with the EU accounting for 44.5 per cent iv of all UK exports so far this year. But, equally, he must be seen to be taking a robust line on Europe to calm his backbenchers and prevent the UK Independence Party from attracting Tory supporters. To placate eurosceptics he has pledged a referendum on any European treaty change that would increase the power of Brussels.
  • 21. UK 21 Viewpoint: Anne Richards, Chief Investment Officer, Aberdeen Asset Management I believe the UK’s relationship with the EU is viewed differently among member countries. Finland, for example, is also part of the eurozone but has very different priorities to the periphery and is not willing to write blank cheques to other countries like Germany. Therefore, I think there are going to be opt-outs of some shape or form from other countries in the EU too. Viewpoint: John Greenwood, Chief Economist, Invesco It is becoming increasingly important for Britain to define a relationship with Europe which involves economics, trade and finance, but leaves some social areas of policy out of that. However there are some politicians who want to buy the whole package: human rights, immigration, civil liberties. This impacts on the stability of coalition and the UK’s relations with other European countries. Unless Cameron, Hague and others can outline more clearly the range within which they want to maintain the relationship and then separate out other areas there is plenty of potential for conflict with other European countries. There are two running sores which complicate Britain’s relationship with the EU. First is the six-yearly EU budget deal. Thanks to an opportunistic alliance between Labour and Tory rebels, parliament has called for a reduction in the UK’s contribution in a non-binding vote. The government is negotiating for a freeze, saying that it unfair to impose austerity at home, while giving more to the EU. Countries which benefit from agricultural subsidies and regional aid from the EU strongly disagree and say that UK is being disingenuous as it already enjoys a 35 per cent rebate on its contributions. For David Cameron, any deal that increases contributions would be a huge failure in the eyes of his party and would increase clamour for a fundamental change in the UK’s relationship with the EU. But Cameron has found an ally in Germany’s Angela Merkel, which strengthens his position and increases the chances he can secure an outcome acceptable to public and party opinion. The budget deal should be completed in early 2013, giving us an indication of shifting relationships within the EU and their likely impact on future negotiations. The second issue is the protection of the UK financial services industry from EU policies that might undermine its global competitiveness. The sector delivered a trade surplus of £46.7bn in 2011 v , and remains a cornerstone of the British economy. While the banking sector is hardly popular at home, its interests are still jealously protected at the EU level. Cameron used his veto in December 2011, derailing an entire EU summit in an attempt to extract guarantees on the protection of the UK financial services industry. A proposed European Financial Transactions Tax (FTT) dismays bankers. This tax, combined with the possibility that a new European Banking Union demand that euro-denominated transactions take place in the currency zone, rather than London, would seriously undermine the City of London. Since Cameron used the veto, the government has walked a narrow line, looking to maintain access to the single market while choosing to opt-out of many eurozone initiatives. The government has had some measure of success but over time this approach will inevitably see the UK drift further from the eurozone core. What could happen next: A referendum in the offing? David Cameron has said there will not be a referendum on the EU until after the election in 2015, though he will likely announce further details about the shape of this referendum – what the question will be and the date it will take place – in early January next year. This may take some of the momentum away from UKIP. Either way, a public referendum on the issue is not a question of if, it is a question of when. When the future referendum occurs, the question posed to the public will be crucial. If the question is simply an ‘in’ or ‘out’, a recent poll vi found that a majority would vote for an exit (see Box 7).
  • 22. 22 UK At present the more likely option is a two-question poll similar to that formulated by former Foreign Secretary Lord Owen: one on remaining part of a renegotiated ‘European Community’ based on trade, and a second on staying in a more integrated EU. Some have suggested that the UK could enjoy a looser relationship with the EU like Switzerland or Norway, which is not politically realistic. The EU has already said there will not be another country treated like Switzerland, which has arguably gained access to the Single Market on easy terms, while Norway complains that it has to implement EU rules without having any say in how they are written. In either scenario, business will be nervous about whether UK access to the EU single market is compromised. While business grumbles about the weight of EU regulation, they also benefit from open access to European markets. The UK having to tediously renegotiate access to these markets, most likely on less favourable terms, would be bad for business. The Foreign Office is already conducting a study on the ‘Balance of Competences’ between the EU and UK with a view to measuring how important the EU is to trade and investment, as well as how well the EU is carrying out its duties. The fact that the study is being conducted at all is significant and its findings will no doubt throw further petrol on the flames. If Cameron were truly in favour of leaving the EU he would call an in/out referendum now. Fortunately for business, and his pro-European Liberal Democrat partners, he is not, and he will not. The EU’s recent budget debates have to some extent changed the game. Fiscally conservative, free-market economies have formed alliances, in turn giving the UK more bargaining power and helping to regain its place at the decision-making table, where Cameron needs to stay to be able to make a pro-EU case to sceptical British voters. The worst case is that the UK drifts out of the EU without any credible strategy in place for its future in a tough global economy. Box 7 In Out Don’t know EU referendum poll Nov 2012 44% 48% 8% Source: Ipsos MORI, November 2012 If there were a referendum on whether Britain should stay in or get of the EU, how would you vote? Viewpoint: Stephen King, Chief Economist, HSBC If Cameron were to give the British people a choice of staying in, renegotiating our agreement or leaving, I think we’d end up leaving, which isn’t really what Cameron wants. Viewpoint: Viewpoint: Head of government relations, leading investment bank The UK Independence Party seem more a party the Conservatives can’t ignore – if they split the Tory vote talking about things the Tories don’t want to talk about for internal reasons, it is very challenging.
  • 23. UK 23 Mark Carney takes over as Governor of Bank of England The central bank gets a new leader with a host of new powers over financial regulation. Carney has suggested scrapping inflation targeting and replacing it with measures based on growth or jobs. The UK’s AAA credit rating The UK is now on negative outlook from all three major ratings agencies. In 2013 it is likely that at least one will downgrade the UK, a serious blow to Chancellor George Osborne’s economic credibility. Scottish Independence With a referendum set for 2014, next year will see the ramping up of the discussion around the pros and cons of Scottish independence. Once again, expect to see Europe a big part of the debate, as accession to the EU is a key plank of the Scottish National Party’s strategy for independence. Banking reform As the ink dries on legislation finalising the new financial services regulatory structure, 2013 will see progress on legislation to reform the banking sector. Debate will focus on the ‘ringfencing’ of retail operations from investment banking operations. Tax Debate will continue to rage about the corporate tax system in the UK and in the EU. ON THE AGENDA – THINGS THAT WILL DRIVE THE DISCUSSION IN 2013
  • 24. EU 24 EU THE EUROPEAN UNION EUROZONE: WHEN THE FIRE IS OUT, WILL LEADERS SEE THROUGH THE SMOKE? The issue: Eurozone leaders lose their sense of urgency and fail to finalise reforms For the past two years eurozone leaders have been in crisis management mode, attempting to contain the acute crisis caused by flaws in the design of the Economic and Monetary Union (EMU). Risks to the future of the eurozone remain, despite the recent relative calm in the markets. In the absence of imminent catastrophe, might leaders be lulled into a false sense of security in 2013 and leave essential reforms unfinished? How we got here: Market lull allows breathing space While the impacts of the eurozone crisis are primarily economic – dismal growth, poor credit conditions and high unemployment – much of the underlying problem is embedded in the politics of crisis management. The troubles began as a sovereign debt crisis in a small euro area state. But the lack of decisive action by the rest of the eurozone has turned this into a chronic political and financial crisis. Businesses and markets have called for a ‘big bazooka’ strategy to create certainty. Instead, eurozone leaders have followed a piecemeal approach of strengthening central control of economic policies. This has led to some progress. The so-called ‘six pack’, which has tightened restrictions on government debt and deficit levels in the Stability and Growth Pact, has now been in force for a year. In addition, the Council of Ministers and the European Parliament are about to close a deal on the ‘two-pack’ of additional regulations giving even more powers to the European Commission to intervene in national budgetary processes. At the same time, the European Central Bank is set to gradually take over the oversight of all banks in the eurozone, enabling the European Stability Mechanism (ESM) to inject capital directly into the banking sector instead of channelling this aid through governments, thereby breaking the negative feedback loop between banking and sovereign risk. However, EU institutions have not fully succeeded in convincing the markets about the efficacy or consistent application of these tools. As such, there is a widespread view that the ESM and the European Central Bank’s actions have provided the currency area with temporary breathing space only. Many difficult political decisions still lie ahead. It is far from clear whether the eurozone emerges from the crisis as a fully integrated and reformed currency area, as an incomplete work, or whether it collapses entirely. Viewpoint: Senior Official, EU The steps already taken to strengthen the Economic and Monetary Union during the past three years are historical and their impact should not be underestimated. The Member States are implementing reforms both on the fiscal and on the structural side. The challenge comes from the short term negative effects of these reforms which create political and social pressure. The year 2013 will be a political acid test. The first half will be very difficult as the reforms take time to translate into economic benefits, and there is a real risk that political instability could further postpone the return to growth.
  • 25. EU 25 Source: The 2012 Euro Plus Monitor – The Rocky Road to Balanced Growth (The Lisbon Council and Berenberg Bank) Box 8 Cyprus Greece Portugal France Italy Spain Ireland Malta Belgium Finland Austria Slovenia Slovakia Netherlands Germany Luxembourg Estonia 0 2 4 6 8 10 More reform required across eurozone countries Adjustment Progress Indicator Fundamental Health Indicator The adjustment progress indicator and the fundamental health indicator give an indication of the effort made by countries to correct their fiscal problems as well as the country’s overall economic health. The higher the score, the more has been done or the better the country’s health. Whilst Greece, Portugal and Ireland have been forced into adjustment, it is remarkable how poorly some of those countries not in crisis score, according to the Lisbon Council.
  • 26. 26 EU What happens next: Without continued reform, could Europe drift back into crisis? After two years in crisis mode, the next source of political risk may have a rather surprising source: relative calm in the markets. The only thing that has galvanised decision-makers into action so far has been the risk of an imminent disorderly sovereign default and the chaos that would follow. The current situation, with the ESM in place and an ECB commitment to support bond markets, must feel like holiday season for European leaders. It would be tempting to put painful and tedious reforms of EMU on the back burner. However this would be a mistake, as half-baked reforms will leave the eurozone ill-equipped to handle looming problems in politically sensitive areas such as competitiveness, ageing populations, structural reforms and the mutualisation of debt. Furthermore, the direct recapitalisation of Spain’s banks by the ESM is postponed until the single eurozone banking supervisor is fully functional, or until the creditor countries give their consent. It would be unfair to say that the eurozone has not come a long way in the past two years in terms of strengthening the oversight of public spending and addressing some of the systemic weaknesses at the heart of the current crisis. But the world needs to be convinced that the eurozone can take a proactive approach, rather constantly fighting fires. Viewpoint: John Greenwood, Invesco In my view, a country will leave the eurozone, but over the next two-to-three years. This could occur by adverse political results such as austerity fatigue in southern Europe or bailout fatigue in the north leading to the election of an extreme party who reject the orthodoxy of staying in the Union. Or it could be caused by an acceleration of last summer’s run on the banks, which outstrips the ability of bureaucrats, politicians or central bankers to keep it under control. The core of the monetary union will survive. There is huge political and other capital invested there so it will be kept together. However the cost of keeping peripheral countries in will be huge, namely after many years of stagnation whilst they deflate their economies until they become competitive again. Viewpoint: Karel Lannoo, Director, Centre for European Policy Studies The eurozone has the tools now – six pack and two pack – but they are not consistently applied to all member states, for example France. Viewpoint: Holger Wessling, General Manager, DZ Bank AG [The crisis] will speed up European integration – what we have seen politically in Europe is that most of the integration has been driven by various external pressures or events…When you look at how much legislation and change is being driven through Brussels at the moment, I think they’ve done in two years the amount they did in the previous ten. Having said that, I do fear that we might leave the man on the street behind. We need to explain to the voters, the people of the European Union, better what’s actually happening and how they will benefit.
  • 27. EU 27 NATIONAL ELECTIONS THAT COULD CHANGE THE COURSE OF THE EUROZONE The issue: Germany and Italy head to polls with eurozone front and centre 2013 will see two critically important elections take place in the eurozone: Italian elections in February and German elections in September. These elections are crucial to the future of the eurozone. How we got here: National politics will have far-reaching effects on the rest of the eurozone Despite the considerable power and influence of the EU institutions, policymaking within the bloc is still largely driven by politics at member state level. This can make domestic elections, particularly in the large countries, crucial. Germany plays the role of reluctant leader of the troubled eurozone. Chancellor Angela Merkel has staked her political future on ensuring German taxpayers are not on the hook for the cost of Greece’s economic meltdown. This unbending position has won her 70 per cent approval ratings at home, but has made her unpopular with European officials who think she has put domestic politics above the interests of the eurozone. The Greek economy has shrunk by more than 6 per cent in 2012, and its total debt burden is on course to reach almost twice its GDP by 2014. There is little prospect that the country can escape its troubles without further support from the rest of Europe, particularly Germany. But if Merkel changes her position on Greece, it could kill her chances in the election. Meanwhile, Italy remains debt-laden, with a shaky economy large enough to bring down the entire eurozone should it implode. Mario Monti’s technocratic government has restored some level of market confidence by pushing through much-needed domestic reforms. But the rise in Italy’s bond yields following Monti’s announcement that he will resign after the 2013 budget is passed, gives some flavour of the kind of reaction that we could see after the elections. Political uncertainty is the last thing that the markets want to see now, but it is possible that Italy will provide it in spades.
  • 28. 28 EU What happens next: German and Italian public have a big choice on their hands There are two reasons why the forthcoming elections pose a political risk. First, the elections may change the countries’ stances towards the EU at a time when crucial decisions need to be taken. The second is the chance that elections could change domestic policies which then have a knock-on effect to the rest of the eurozone. In Germany, it is likely that Angela Merkel will continue as Chancellor. The question is, with whom? Frau Merkel’s current CDU/CSU/FDP coalition may falter even before the election. Regional elections in January could see her lose a majority in the federal Senate, meaning that laws could be effectively overturned by the socialist SPD and Greens in the upper house. Nationally, a December poll for the Bild newspaper showed Merkel’s coalition with 42 per cent support, the same level as combined support for the SPD and Greens. This close race opens the possibility of a grand CDU/SPD coalition in 2013. What might happen after the German elections? With voting out of the way, the government may be more willing to take the unpopular decisions that are needed to lift the eurozone out of its current mess. The other possible scenario could be that Merkel takes the election victory as a mandate to continue with her current tough policies and that little will change. A major turnaround in Merkel’s policies on the eurozone seems unlikely. As German socialist MEP Peter Simon noted in December 2012, the next election is always just around the corner; after the 2013 national elections 16 state level elections will follow. This will prevent leaders from straying too far from public opinion. In Italy, the election result is unpredictable. Centre-left Democrat candidate Pier Luigi Bersani’s clear-cut victory in the primary run-offs on 1 December 2012 seemed to solidify his place as frontrunner to succeed Mario Monti as Prime Minister. However, the political scene has changed rapidly over the course of December. Silvio Berlusconi may throw his hat into the ring, while European leaders are reportedly imploring Monti, whom they trust and respect, to run on a platform of continuity. Opinion polls show the Democrats well ahead, with support of about 30 per cent of the electorate, profiting from the disarray in Berlusconi’s People of Liberty party, which is trailing at 16 per cent. In all probability, no lasting solution will be found to the systemic economic problems facing the eurozone, particularly in terms of additional decisions on Greek debt before the German election is safely out of the way. Eurozone partners and debt markets will also be watching Italy’s elections closely. If it looks like the progress made by Monti is at risk of being reversed, the outcome may be grim. The voters of Germany and Italy have a big choice to make in 2013.
  • 29. EU 29 Box 9 EU Member States where the incumbent Government has lost power (2009 onwards) UK Spain Italy France Romania Netherlands Greece Finland Malta Slovakia Slovenia Denmark Portugal Belgium Ireland Hungary Germany Poland Lithuania Estonia Austria Luxembourg Sweden Bulgaria Latvia Czech republic Cyprus Leadership that has changed Leadership that has survived
  • 30. 30 EU Viewpoint: Anne Richards, Chief Investment Officer, Aberdeen Asset Management Going into 2013 parliamentary elections in Germany will be a key event in the developed world. The future of the European banking sector, the euro and the European sovereign bond markets will depend on Germany’s willingness to continue to accept the role it has held so far held. There is the potential for a surprise result as so far in virtually every European election we have witnessed fringe parties gaining support for not supporting austerity measures. Viewpoint: Holger Wessling, General Manager, DZ BANK Unless we see any major external shocks, possibly resulting in increased German unemployment, I think that Chancellor Merkel herself carries sufficient goodwill in the population to be re-elected. It’s less the case for her party; she will carry the so-called Chancellor bonus, which I think will most likely get her through, but I would think it will be a tighter majority for the existing coalition government of CDU/CSU and FDP. Viewpoint: Viewpoint Karel Lannoo, Director, Centre for European Policy Studies What will happen in Italy is difficult to predict. In Germany, Merkel will face the additional challenge of controlling different factions of her own party. A PROTECTIONIST SHIFT The issue: Will the EU start raising economic barriers? The economic crisis has forced the EU to focus its efforts on internal issues. Rising unemployment and public discontent have brought about changes in government in many EU countries. In the face of economic weakness, will politicians adopt an increasingly protectionist agenda? And are we witnessing the emergence of a more inward-looking European Union? How we got here: Crisis strengthens calls to protect domestic industry The economic crisis has fuelled public discontent with incumbents. As a response, we have seen the rise of populist and nationalistic voices in some parts of Europe, both in the weaker south and in the stronger north. Some call for ‘less Europe’ and others for more protectionist trade policies. The first revision in 30 years of the Generalised System of Preferences (the EU’s framework for preferential tariffs towards developing countries) was concluded in October 2012 and as a result, many of the wealthier developing countries will lose their preferential treatment. Meanwhile, France is trying to boost its troubled car industry not only through domestic subsidies but also by requesting the EU to put its free trade agreement with South Korea, a major automobile exporter, under surveillance. “The EU is the only one that does not protect itself against unfair competition. We have become the idiots of the global village,” French Minister of Industry, Arnaud Montebourg
  • 31. EU 31 In addition, the EU has focused much of its energy on crisis management, arguably taking its eye off a longstanding commitment to free trade, an area where the EU has significant clout. The situation has not been helped by stalled WTO negotiations, which have killed the prospects of a comprehensive multilateral trade agreement. Finally, one of the most vocal proponents of trade liberalisation, the UK, appears to be drifting away from the EU. What happens next: Hopefully, new trade talks come to a successful conclusion The single market is one of the greatest assets and trade policy is one of the few areas where the European countries speak with one voice. But an export-led recovery driven by the many sectors where Europe has a competitive advantage has seemingly been forgotten by some politicians. Emerging economies which import European luxury goods, cars and airliners are often portrayed more as a threat than as an opportunity. Giving in to calls for populist and protectionist measures will only delay necessary structural reforms and hurt those industries that remain competitive. In addition, some of the policy responses to the eurozone crisis could risk wearing down the competitiveness of those industries that are dependent on a level playing field with the rest of the world. The financial services sector is one example where the popular pressure has taken precedence over international competitiveness. Even if these pressures are a temporary turn, they may have longer-standing consequences than are immediately obvious. The European Commission, the EU’s representative in all trade negotiations, consists of commissioners appointed by their respective governments. Therefore, if the national governments embrace more protectionist policies they may also be inclined to support electing a cabinet of commissioners sharing this approach. This commission will stay in power between 2014 and 2019, which is much longer than anyone would like to see the current crisis lasting. Viewpoint: Head of government relations, leading European investment bank Economic protectionism and nationalism both at EU level and amongst individual states is a real risk. We have a single market that seems to be under huge pressures. The whole rationale of the EU is to have free-flowing cross-border trade. But we have been seeing defensive responses over the past four years. There is talk of a US-EU free trade agreement, but that is unlikely to happen, with negotiations likely to last for many years. The whole idea of a single market is quickly eroding. What we are seeing is balkanisation with 27 governments answerable to their taxpayers. This protectionism is a severe challenge to the EU’s DNA. Viewpoint: Patrick Nolan, Chief Economist, Reform Governments are much more likely to put short- term national, political interest ahead of the interests of a multinational company which is seen as good for long-term growth... I think the hostility of the environment makes regulatory coordination more important, not less “That governments resort to discrimination against foreign commercial interests during global economic downturns is well known. “History shows that the forms of protectionism tend to change during crises and that such protectionism prevails well after national economies have recovered” Simon J. Evenett 11th Global Trade Alert Report Optimists hope that a bilateral EU-US free trade agreement, currently under discussion, and an ambitious trade negotiation with Japan will help the EU deliver a useful blow for enterprise and trade. While the US in particular is not known for swift ratification of trade deals, and there are many sceptics about what will ultimately be achieved, it is essential the EU shows that it remains open for business.
  • 32. 32 EU Completing the Banking Union With the first pillar of the European Banking Union – the Single Supervisory Mechanism – close to completion, the two remaining elements, namely a common resolution mechanism and an integrated deposit guarantee are equally important to prevent future crises and to avoid further fragmentation of capital markets. However, these will entail a much greater degree of risk sharing and will therefore be much more difficult to agree on. In financial regulation more widely, the ability of the EU and the US to recognise each others’ regulatory structures and supervisory structures is a serious worry that could negatively affect cross-border financial flows, with the pair failing to see eye-to-eye on the issue at present. Conflicts in neighbouring countries Europe is close to many ongoing and potential conflicts. A conflict between Iran and Israel is possible, while the civil war in Syria is drawing the attention of European leaders. The EU is not known for its capabilities in the field of foreign and security policy. But more may be expected from the Nobel Peace Prize winning organisation in the future. Finalising EU’s long-term budget The negotiations to agree the next Multiannual Financial Framework for 2014-2020 are stuck due to disagreement between those wanting to spend more and those not willing to increase their contribution. Agreement will have to be found in 2013 and the outcome will influence both the EU and its Member State policies until the end of the decade. ON THE AGENDA – THINGS THAT WILL DRIVE THE DISCUSSION IN 2013
  • 33. 33 ASIA PACIFIC MARITIME DISPUTES: MAKING WAVES IN ASIA The issue: Tensions are rising over the South and East China shipping routes The South and East China seas are very important shipping routes and are also home to large oil and gas reserves. A major concern is that tensions arising from competing claims by bordering countries to these resources could escalate into conflict. Many countries in Asia – China included – are not energy sufficient and resource consumption is set to rise as the region continues to develop. The Asian Development Bank predicts that Asia will produce in excess of 40 per cent of the world’s greenhouse gas emissions within the next 10 years. Viewpoint: John Greenwood, Chief Economist, Invesco Perpetual Hugely increased tension in Asia between China and Japan over the disputed islands means there is a growing risk of clashes. That would be very disturbing to financial markets. Box 10 Source: US Energy Information Administration 60 05 1108 14 1706 1209 15 1807 13 1610 2019 90 120 150 Consumption(QuadrillionBtu) China’s energy consumption set to double on 2005 levels by 2020 vii Year (20XX)
  • 34. 34 ASIA The resource issue is so important that even India, which has no maritime claims in the area, has threatened to use force if necessary to defend its commercial oil and gas interests off the coast of Vietnam. In early December, Indian Navy Chief Admiral D. K. Joshi was reported by Reuters as stating that the Indian navy was preparing for intervention if necessary. The second issue is trade and maritime security. Home to some of the world’s busiest and most important shipping lanes, freedom of navigation is a strategic issue not just for the countries bordering the seas but for the wider world. How we got here: A fractious history The issue is complex and needs to be viewed in the context of historic hostility, much of it emanating from the Second World War, and concerns, especially in Japan and south east Asia, about a more assertive China. The key issue is Asia’s growth and the demand for resources. The South and East China Seas are resource- rich, bordered by many countries, and maritime boundaries have not yet been defined. Maritime borders are governed by the United Nations Convention on the Law of the Sea but this 1982 convention fails to resolve ownership differences in the China Seas. A number of guidelines are in place, such as exclusive economic zones but it is up to countries in the region to resolve overlapping maritime claims by negotiation, and no country in the region is willing to give up its claims. The issue is escalating politically, with the outgoing Secretary General of ASEAN warning that “we have to be mindful of the fact that the South China Sea could evolve into another Palestine”. China has recently started issuing new passports with a map claiming sovereignty over disputed territory. This has angered its neighbours, particularly Vietnam and the Philippines, whose immigration officials refuse to stamp the new passports. In December, Vietnam witnessed a series of anti-China protests – a country where protests are very rare. Similar protests have taken place in Japan, stoking deep-rooted hostility between the countries. Protests are not one-sided. In September, anti-Japan protests escalated in China following the purchase by the Japanese government of the disputed Senkaku islands from a private Japanese owner. The demonstrations escalated to such an extent that some Japanese businesses had to suspend operations in China on safety grounds. What happens next: The issue will remain firmly on the agenda Despite attempts by China to remove the issue from agenda of regional gatherings such as the East Asia Summit, it is not going away. The United States is bolstering its presence in the region and we are likely to witness an escalation of tensions throughout 2013, especially in the East China Sea. Japan-China relations are complex, and although there is much official rhetoric and grass-roots level hostility, it is unlikely that either country would want to see the issue escalate into full-scale conflict. Trade and economic relations between the two countries are too important to be compromised by the Senkaku islands. Japanese investment in China is large, and China as a consumer market for Japanese products is increasingly important in an era when the traditional export markets of Europe and the US are depressed. The recent election results in Japan confirmed a victory for the nationalists, who will take a harder line against China. Shinzo Abe, leader of the winning Liberal Democratic Party, immediately stated that “The Senkaku islands are Japan’s inherent territory… There is no room for negotiation on this point”. In response China’s Ministry of Foreign Affairs stated that it is “highly concerned about which direction Japan will take”. The LDP is unlikely to compromise on the issue, and the Senkaku islands will be a thorn in the side of China-Japan relations for years to come. “The risk of conflict in the South China Sea is significant”. US Council on Foreign Relations
  • 35. ASIA 35 Viewpoint: Sirpa H. Ikola, Board Member, European Chamber of Commerce Singapore Anti-Japanese sentiment in China, reinvigorated by the current island disputes, has the potential to cause instability in Asia. Viewpoint: Garich Lim Shington, Director, Seaward Chemicals China has huge and growing energy resource needs. These needs cannot be met by energy reserves in China alone, which is compelling China to seek alternative sources of energy resources and raw materials. The South and East China Seas are reportedly home to vast amounts of resource reserves and China is unlikely to compromise on its maritime claims. Viewpoint: Chanunrat Thienviroj, Associate, Singapore- based import-export company The South China Sea issue is a major concern to companies like mine, who rely on free and open shipping lines. The status quo is fragile, and given that most trade in the region passes through the South and East China Seas, any conflict in the region could have a drastic effect on intra-ASEAN and intra-Asia trade flows. The election results in Japan have definitely raised the temperature. The United States will continue to monitor the issue and build its military capabilities in the region. This will present difficulties for both Singapore and Australia who host US military bases. While both of their economic interests lie with a resurgent China, they depend on the United States for security. On a practical level, ASEAN, which has many members with South China Sea interests, has proposed the establishment of a hotline with China to help diffuse tensions and misunderstandings involving the dispute. What is clear is that the risk of escalation is high, and maritime disputes in the region threaten to overshadow the regional trade, economic and political agenda throughout 2013.
  • 36. 36 ASIA AN ASEAN-CENTRIC ASIA? The issue: Overlapping trade agreements and the future of ASEAN The world economic crisis and resultant dampened demand in the West has led many countries in Asia to reappraise their trade policy and economic policy. At the trade level, policymakers and politicians are working to boost intra-Asia trade, which has historically been low. Measures are being put in place to boost the domestic consumption of GDP and improve trade-related infrastructure (both financial and physical) to help Asian economies trade with each other. Part of this process involves trade liberalisation and regulatory harmonisation and the Association of South East Asian Nations has been leading the way. ASEAN is fast becoming the region’s premier intergovernmental decision making forum. Although ASEAN’s membership itself is limited to 10 South East Asian countries, the East Asian economic giants of China, Japan and Korea meet on the sidelines as the ASEAN+3 grouping. ASEAN is becoming a catalyst for Asian integration and at the recent East Asia and ASEAN Summits in Phnom Penh, Asian leaders agreed to pursue three complementary trade agreements, with negotiations starting in 2013: 1. A trilateral free trade agreement between China, Japan and Korea; 2. A regional comprehensive economic partnership (RCEP) of East Asia (including ASEAN); 3. A consolidation and harmonisation of ASEAN+1 trade agreements, such as the ASEAN-China FTA (Free Trade Agreement), the ASEAN-Korea FTA and the ASEAN-Japan Comprehensive Economic partnership. What is clear about these three agreements/negotiations is that ASEAN is taking centre stage. It already has FTAs with Korea, China, and a comprehensive economic partnership with Japan. Indeed Japan is engaging significantly in the region. It provides substantial development assistance to South East Asia and provides funding for many organisations, including the ASEAN Foundation. As a region of over 500 million people, it is equally clear that South East Asia is fast becoming one of the world’s most important consumer markets. The political issues though are two-fold: 1. Can ASEAN, with its diverse populations, cultures and stages of development sufficiently integrate into a truly single market and trading bloc? 2. The relative spheres of influence of China and the United States.
  • 37. ASIA 37 How we got here: Cautious integration Asian regional integration, particularly around trade, has been a long process and is far from the levels of integration we see in the European Union. Although the ASEAN has been around since 1967, it wasn’t until the 1997 financial crisis that leaders in Asia became serious about regional economic integration. The 1997 crisis led to the development of the Chiang Mai Initiative Multilateralisation (CMIM), a multilateral currency swap arrangement among ASEAN+3 to help member economies deal with future short-term liquidity problems. The CMIM was the catalyst for further regional integration through the ASEAN+3 grouping, with South East Asia at its core. However, significant challenges remain to the process of economic integration. A number of factors can explain this: vastly differential levels of industrialisation, a lack of trade integration (currently about 25 per cent of trade in the region is intra-ASEAN), differing political and legal systems, historic hostility between many countries in the region and an unwillingness to cede power away from the nation state. ASEAN as an institution is intergovernmental in nature and it is highly unlikely that a supranational system – such as that seen in the EU – will develop in South East Asia. This is reflected in ASEAN’s small operational budget which in 2012 stands at just over US$15m, and will only increase by 3 per cent in 2013. ASEAN+3 leaders meet on the sidelines of ASEAN ministerial summits and a quasi-secretariat – the ASEAN+3 Macro Economic Research Office – was officially launched in Singapore in 2012. The major development of 2012 has been the evolution of the ASEAN+3 grouping into a potential East Asian trade bloc. However, ASEAN+3 members disagree on their relationship with the United States and other regional players such as Australia and New Zealand. China in particular is keen to ensure that ASEAN+3 is the premier regional body to the exclusion of the involvement of the United States. This stance is backed to some extent by Malaysia (which, paradoxically, is participating in the Trans-Pacific Partnership – or TPP – negotiations), but Japan, Singapore and the Philippines favour a more international trade grouping, involving the United States, Australia and New Zealand. At the same time a parallel trade initiative, under the auspices of the Asia Pacific Economic Cooperation (APEC), is seeing a select group of Asian and Pacific countries negotiate a free trade agreement. Although more geographically disparate, the countries of the TPP negotiations are select and perhaps more likely to be successful in negotiating a free trade area. The United States is particularly keen to see the TPP succeed, as it is a forum through which they can maintain their influence in the region. Trans-Pacific Partnership Regional Comprehensive Economic Partnership East Asia Trilateral Australia Brunei Canada Chile Malaysia Mexico New Zealand Peru Singapore United States Vietnam ASEAN (10 member states) Australia China India Japan New Zealand South Korea China Japan Korea Box 11 Trade agreement negotiation partners
  • 38. 38 ASIA What happens next: Competing trade agreements and a race to the finish TPP negotiations are advanced and a tentative deadline for their conclusion has been set for the APEC leaders summit in Bali, Indonesia, in November 2013. It should be noted that this is a tentative deadline – the TPP has in the past had numerous deadlines which have not been met – leaders are therefore cautious about committing to a formal deadline. ASEAN+3 negotiations are even more complex and involve a consolidation of existing ASEAN+1 agreements, the negotiation of a trilateral FTA between China, Japan and Korea (which could potentially be overshadowed by the South and East China Seas issue), and a regional comprehensive economic partnership between ASEAN and their regional partners in Asia. These negotiations are yet to get off the ground, but are scheduled to commence in early 2013. The key political issue to be resolved centres around the relative influence in the region of the United States and China. Japan, also, has been active in pushing its interest in ASEAN and the nationalist victory at the recent general election will increase the status of ASEAN as a “battleground” of competing interests and spheres of influence of the bigger powers. Viewpoint: Sirpa H. Ikola, Board Member, European Chamber of Commerce Singapore The promise of a single market of 600 million people by 2015 has evoked the interest of many of the world’s economic powerhouses. It seems that both the US and China are competing for the attention and influence of ASEAN, but so is Russia, Japan and the European Union. The expectation is that ASEAN remains neutral and united within their group. Is this possible? Viewpoint: Hugh Vanijprabha, Executive Director, Thai- European Business Association The first priority of ASEAN is to create one community. Achieving a critical mass of acceptance of this concept of one community amongst the people of ASEAN is the key milestone. Education, both on and off campus, plays a significant role to promote awareness and at the same time, harmony amongst the people of ASEAN. The next step is to then how combined strengths can be harvested. Viewpoint: Brigitte Holtschneider, Executive Director, British Chamber of Commerce, Singapore The overarching key challenge for ASEAN will be to prove it can operate as a real economic union and be the often cited market of about 600 million people in South East Asia. Prosperity and development divides between the member states are still rather significant which may keep protectionist tendencies longer than helpful for the common goal. The postponement of the Single Window 2015 to the end of 2015 is testament to this. Another key challenge in my view is the successful integration of Myanmar. Respect for Human Rights and political freedom is least developed in this country and dealing with it as a union is going to be critical for success. Viewpoint: Kuek Yu-Chuang, Board Director, Asia Internet Coalition Cross-border data flows are the new trade routes for Asia and beyond. Asia’s future success will hinge on the ability of individual economies to keep these trade routes open and free. Artificial barriers that impede data flows would greatly stymie growth in the region. Viewpoint: Vikas Sharma, Principal Consultant, Frost China has become an indispensable partner for the ASEAN. For three years running, China has been the largest trading partner for the ASEAN bloc, with bilateral volumes topping USD $200bn a year. Chinese companies looking for regional growth are investing heavily in ASEAN nations and China has offered financial support to ASEAN through funding and preferential credits to support infrastructure projects. Even in the USD $240bn strong regional financial safety net, CMIM, China is the joint-largest contributor. The Xi administration will use this position of strength to persuade ASEAN nations not to join Washington’s alleged China containment policies and to strengthen its credentials as the region’s pre-eminent geopolitical power.
  • 39. ASIA 39 CHINA’S LEADERSHIP: A NEW GENERATION TO SHAPE THE NEXT DECADE The issue: Challenges ahead for China’s new leadership For the first time in a decade China has ushered in a new cadre of leaders. A smaller than usual cohort of seven men will lead China for the next decade. The process of leadership renewal began years ago but it was in November that the world got a glimpse of the next generation of Chinese Communist Party leaders. These Party leaders will take over the leadership of state functions in March 2013. Although conservatives – supported by former leader Jiang Zemin – dominate the leadership, both Xi Jinping (the next President) and Li Keqiang (the next Premier) are likely to pursue warm relations with the West and the United States in particular. The real issue at stake though is whether China’s economic reforms can remain on track – Xi Jinping is less economic reform minded than his predecessor Hu Jintao and whilst the Chinese economy is comparatively strong, key challenges lie ahead, in particular dealing with China’s demographic situation and supporting an increasingly ageing population. These challenges are not unique to China – Japan, Singapore and many countries in the West are having to deal with such challenges – but the danger is that China’s population will age before it becomes a truly rich country.
  • 40. 40 ASIA China is not immune to the global economic downturn. The country’s post-crisis fiscal stimulus is unsustainable in the long run and the new leadership is likely to focus on economic rebalancing away from export and investment-led growth in favour of greater domestic consumption. The World Bankviii has recently revised down its 2012 growth forecast for China from 8.2 per cent to 7.7 per cent. According to the World Bank’s East Asia and Pacific Data Monitor for October 2012, the growth downgrade is in part due to a fall in investment demand – in 2011 consumption demand contributed more to GDP growth than investment demand for the first time since records began. The report states that “Some observers see this as the start of a trend in domestic rebalancing, and associate this with a more permanent growth slowdown in China”. How we got here: Careful planning! The leadership changes announced in November concern the leadership of the Communist Party of China, which has been in power since 1949. At a meeting of the National Congress of the Communist Party of China a new generation of leaders were anointed. However it won’t be until 2013 that the new leaders will take over leadership of the State at the annual meeting of the National People’s Congress in March. Held once every five years, National Congress of the Communist Party of China (CPC) is the leading body of the Party. A central committee with approximately 350 members and alternates is elected at the National Congress to carry out the party executive’s decisions, from this committee a group of leaders are selected to form the politburo, which will eventually become the State Council – China’s equivalent of a cabinet – at the annual National People’s Congress in March. Leadership changes in China are planned and, at face value, stable. There is less traditional “political risk” as China is not subject to the same levels of uncertainty thrown up by democratic elections. However, not everything goes as planned and as the Communist Party and organs of the state are vast, a key challenge for the leadership will be to maintain loyalty to the Party (and therefore government) and exercise sufficient control to root out corruption. What happens next: Guarded reform The politburo will take over the leadership of the Chinese state at the National People’s Congress in March. While much of the agenda of China’s new leaders is known, the NPC will be an opportunity for more detailed announcements on the future direction of China’s economic and industrial policy. The anti-corruption drive is likely to dominate the domestic agenda and many in China are beginning to question the actions and behaviour of local officials and leaders. The scandal of Bo Xilai’s wife poisoning British businessman Neil Heywood was a rare public exposure of the excesses of some of China’s leadership. There is a growing sense of unease that some at the top can act outside the boundaries of the law. Xi Jinping has made clear that at the top of his agenda will be eradicating corruption. In an article for China’s People’s Daily, he encouraged party members to “be brave in conducting criticism and self-criticism, take the lead to spread a healthy spirit, and reject unhealthy trends and evil influences” The second domestic issue that the new leadership will have to grapple with when it formally assumes office in early 2013 is to continue with a restructuring of the Chinese economy. The US National Intelligence Council in its latest “Global Trends” assessment states that China is likely to surpass the US as the world’s largest economy by 2030. However, it also warns that significant challenges lie ahead. These include the effects of China’s one child policy, which has led to a significant gender imbalance (which, in turn, could lead to social unrest), a rapidly ageing population and rising inequality.
  • 41. ASIA 41 Box 12 Source: United Nations ix 0 2060204020202015201020052000198019601950 2080 2100 10 20 30 40 50 60 Age(years)/Dependancyratio Demographic Trends in China Year Old age dependency ratio Median Age Although China still has an enviable growth rate, there is a need for China to reduce its reliance on government investment and export-led growth. Domestic consumption has to rise as a proportion of GDP and this requires a more equitable distribution of the proceeds of economic growth and a move to higher value-add production. These challenges require economic restructuring and a dismantling of China’s state-owned enterprises. This will be no easy task as SOEs are some of the most entrenched interest groups in the country; they have been the conduit through which the Chinese government has stimulated the economy to insulate it from the global economic crisis, and they are a training group for many of China’s most influential officials. The State Council has asked policymakers and academics in China to draw up an ambitious economic and structural reform plan over the next few months. In addition to reforming China’s SOEs are likely to be policies to reform: • China’s fiscal structure – likely to be simplified, and more localised. Currently central government collects most of the tax revenues but local authorities are responsible for spending. This has led to a serious fiscal disconnect and dealing with China’s local government debt is a key priority; • Increasing the convertibility of the yuan; • Reforming the interest rate system so that the market determines the cost of bank credit; • Further opening up the price of land and natural resources to market forces. These are just some of the main economic challenges China faces in the years to come and the first opportunity to formally hear the new leadership’s economic priorities will be at the National People’s Congress in March.
  • 42. 42 ASIA Viewpoint: Vikas Sharma, Principal Consultant, Frost & Sullivan Asia Pacific The Xi administration needs to relook at the exports-oriented development model that has fuelled China’s rise as an economic superpower. As demand from key export markets like the US and the EU seems likely to remain anemic in the foreseeable future, boosting domestic consumption would need to be prioritized. Viewpoint: John Greenwood, Chief Economist, Invesco In China, the new leaders should re-orientate economy away from the export-led model. But this is very difficult to do. For 30 years they have been building an export-oriented economy and a lot of government programmes provide subsidies, benefits, tax incentives for investment and exports. The huge investments in ports, rail, and factories is all export orientated. But domestic infrastructure (e.g. hospitals, shopping malls, housing, particularly in the interior) have lagged far behind. There is a major requirement to rebalance things. But the problem is that the easiest thing is to grow exports- the plants are there to re-absorb the unemployed. Viewpoint: Anne Richards, Chief Investment Officer, Aberdeen Asset Management Xi hasn’t come in with a mandate to change; he’s come in because the establishment think he will continue to support current policies.
  • 43. ASIA 43 Iran/Israel One of the biggest threats to global security is the Iran/Israel issue. With 35 per cent of sea- traded oil flowing through the Strait of Hormuz, the world could suffer a major oil price shock should tensions between the two countries escalate and Iran blockades the Strait. Israeli leader Benjamin Netanyahu is particularly bullish and in November told Israel’s Channel 2 “As long as I am prime minister, Iran will not have the atomic bomb… Israel is ready to act”. Asian Bond Markets Initiative The ABMI is one of the single biggest regional financial services initiatives in Asia. The fixed income market needs to be developed, especially if Asia’s infrastructure needs are to be sustainably financed. The ABMI is one of many initiatives, but leaders will be hoping for tangible progress in 2013. ASEAN Economic Community ASEAN leaders have set a deadline of the end of 2015 for the completion of the AEC. This is ambitious and unlikely to be achieved, but with eighteen months to go, Brunei, the ASEAN chair for 2013, will be hoping to make up lost ground under Cambodia’s chairmanship in 2012. Of particular interest to the banking sector is the recent announcement of a Qualified ASEAN Bank Scheme, whereby regional banks will be given an ASEAN “passport” to offer services across South East Asia. As with most ASEAN initiatives, the plans are ambiguous and lack detail. North Korea Pyongyang launched a long- range rocket at the beginning of December, another milestone in North Korea’s nuclear capability ambitions. The US and Japan have expressed deep concerns, but China, was more muted in its response. Although a historical ally of North Korea, further posturing by Kim Jong Un could lead to Beijing re- appraising its approach. Burma Ethnic clashes, particularly in Myanmar’s Arakan province, threaten to overshadow the reform process. Aung San Suu Kyi has warned about the risk of a “mirage of success”. ON THE AGENDA – THINGS THAT WILL DRIVE THE DISCUSSION IN 2013
  • 44. 44 Footnotes http://www.newyorkfed.org/research/national_economy/householdcredit/DistrictReport_Q32012.pdf Guardian/ICM Poll, 20 November 2012, http://www.icmresearch.com/guardian-poll-november-2012. Ibid. Allister Heath, Business needs to engage in shaping Britain’s post-EU future, The Telegraph, November 2012 Office of National Statistics, March 2012, Balance of Payments, 4th Quarter and Annual 2011 Dataset, http://www. ons.gov.uk/ons/rel/bop/balance-of-payments/4th-quarter-and-annual-2011/tsd-bop-time-series.html Ipsos MORI, November 2012, Public divided on our future with the European Union, http://www.ipsos-mori.com/ researchpublications/researcharchive/3075/Ipsos-MORI-Political-Monitor-November-2012.aspx http://www.eia.gov/oiaf/aeo/tablebrowser/#release=IEO2011&subject=0-IEO2011&table=1-IEO2011&region=0- 0&cases=Reference-0504a_1630 http://www.worldbank.org/content/dam/Worldbank/document/EAP-Data-Monitor-October-2012.pdf United Nations http://esa.un.org/unpd/wpp/country-profiles/pdf/156.pdf. The dependency ratio is the ratio of the population aged 65 years or over to the population aged 20-64. i ii iii iv v vi vii viii ix
  • 45. USA 45 Appendix Panel of experts: John Greenwood, Chief Economist, Invesco Brigitte Holtschneider, Executive Director, British Chamber of Commerce, Singapore Sirpa H. Ikola, Board Member, European Chamber of Commerce Singapore Stephen King, Chief Economist, HSBC Karel Lannoo, Director, Centre for European Policy Studies Will McBride, Chief Economist, Tax Foundation Patrick Nolan, Chief Economist, Reform Jason Peuquet, Research Director, Committee for a Responsible Federal Budget Anne Richards, Chief Investment Officer, Aberdeen Asset Management Vikas Sharma, Principal Consultant, Frost & Sullivan Asia Pacific Garich Lim Shington, Director, Seaward Chemicals Hugh Vanijprabha, Executive Director, Thai-European Business Association Holger Wessling, General Manager, DZ Bank AG Bob Williams, President, State Budget Solutions Kuek Yu-Chuang, Board Director, Asia Internet Coalition Additionally, a number of industry representatives contributed off the record comments, having asked to remain anonymous.
  • 46. 46 About Cicero Cicero Group is an international consultancy specialising in corporate communications, digital strategy, government affairs, political risk and thought leadership generation for policy, business and consumer audiences. For more information please contact: John Rowland Senior Country Officer Tel: +1 202 280 6373 Email: John.Rowland@cicero-group.com Iain Anderson Director and Chief Corporate Counsel Tel: +44 (0)20 7665 9532 Email: Iain.Anderson@cicero-group.com www.cicero-group.com London 1-2 Lower James Street London United Kingdom W1F 9EG Brussels 2nd Floor 14 Rue de la Science, Brussels, Belgium 1000 Brussels Washington DC 1455 Pennsylvania Ave NW. Suite 400 Washington DC, 20004 United States of America Singapore Level 24, 1 Raffles Place Singapore 048616 Singapore Design by Kris Makuch