A generation ago, many wondered how many years would pass before American dominance and, by extension, the clout of Western-led financial institutions like the IMF and World Bank faced a serious challenge. So far, no single rival has proved its staying power. For better and for worse, the IMF and World Bank remain core components of international politics and development. And that's what makes collective action among the BRICS-Brazil, Russia, India, China, and South Africa-so intriguing. The BRICS carry considerable weight as models for the next wave of developing countries-particularly following an American-made financial crisis and ongoing turmoil in the Europe.
It's no surprise then that plans announced last month to create a BRICS development bank have generated so much buzz. In particular, the ability of leading emerging market governments to finance big infrastructure construction projects across the developing world has interesting potential implications.
Yet, for many of the same reasons that the BRICS have so far struggled to institutionalize a working partnership in other areas, this bank will take longer to build than its architects think and will never realize the grand ambitions of its most forceful advocates.
It's no secret that Brazil, Russia, India, China, and South Africa are home to quite different political and economic systems and face different sorts of challenges. Less well understood is the diversity of their interests in creating a bank. Questions of seed money, oversight, purpose, and where the bank might be headquartered are certain to arouse controversy.
But the larger problem is that all the BRICS except China are grappling with sharper-than-expected economic slowdowns-and Brazil, India, South Africa, and Russia are all looking to spend their revenue on infrastructure projects at home to help bolster growth. For the moment, none of them can afford to invest substantial sums to build someone else's roads, bridges, and ports.
These governments face a choice. They can contribute to a BRICS bank funded in equal (modest) parts by each member and lacks the capital to accomplish much. Or they can lend their names to a much-better funded institution that is thoroughly dominated by China.
Yes, Brazil's government is interested in promoting a South-South development strategy, but the Dilma Rousseff administration is now focused mainly on reviving domestic growth following a significant slowdown last year. Its strategy rests in part on using state development bank BNDES to fund ambitious infrastructure projects inside Brazil. If the BRICS bank can be used to finance projects outside Brazil to which BNDES is already committed, it might be useful, but don't expect the Rousseff administration to offer significant new cash commitments toward these projects.
Russia's government, also faced with sluggish growth, will talk up the need for a counterweight to U.S.- and European-dominated institutions, but tepid pledges of support for the bank from Russia's finance minister and the recent tragicomedy in Cyprus make clear that Moscow is not ready to finance its bid for greater international prestige with substantial sums of cash.
Political officials in India, where national elections loom next year, are too preoccupied with a steady stream of domestic troubles to devote much capital to a BRICS development bank, and the government remains deeply ambivalent about its often troubled relations with fast-expanding China. That's in part why India's finance minister has said that the BRICS bank will complement, not challenge, existing international lending institutions.
Then there is South Africa, a country with a growing middle class but chronic high unemployment and an economy the size of China's sixth largest province. The ruling African National Congress sees obvious value in deepening trade and investment relations with China, but its greatest near-term contribution to a BRICS development bank will probably be limited mainly to providing its headquarters a home.
Finally, the bank faces obstacles even within China, the one country than can afford to give it heft. China already has a development bank. It's the most powerful financial institution in the country, one that answers only to the State Council, giving it the status almost of a government ministry. In fact, though the China Development Bank and the China Export-Import Bank may lack the perceived legitimacy of multinational institutions, they don't lack for borrowers. Together, they already lend more to developing countries and companies -- more than $100 billion per year -- than the IMF and World Bank do, extending China's strategic influence throughout Africa and Latin America, in particular.
Why share credit and benefit for these efforts with the other BRICS, especially when the rest have so much less to contribute? And why give others a say in where Chinese funds are invested?
All five of these governments have an interest in choreographed displays of unity and rhetorical challenges to U.S. power. But like so many other aspects of BRICS cooperation, there is less to this bank than meets the eye.
Willis Sparks is director in Eurasia Group's global macro practice.
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As we wrote last August, some governments are watching political developments in Venezuela more closely -- and with more anxiety -- than others. For the past decade, that country's Petrocaribe program has helped 18 Central American and Caribbean leaders avoid the kinds of tough economic choices that sometimes drive angry citizens into the streets -- and helped Hugo Chávez extend his regional influence. Each of these countries has benefited from concessional financing schemes for their imports of Venezuelan crude oil, as well as Venezuelan support for infrastructure projects and social programs. Beneficiaries, especially Cuba, will be watching closely as Venezuelans go to the polls on April 14 to elect Chávez's successor.
They can expect good news and bad news.
The good news for them is that acting-President Nicolas Maduro, Chávez's hand-picked successor, is highly likely to win. Opposition leader Henrique Capriles Radonski is back for another run after losing to Chávez in October, but following a campaign that is likely to prove nasty, brutish, and short, Maduro will benefit from still-strong popular support for Chavismo, public sympathy for those close to Chávez, and fear that the opposition would reverse the late president's most popular policies. Maduro and his allies will also have the resources and political leverage to boost spending and mobilize supporters.
The bad news is that policy is unlikely to improve under a Maduro administration, and political conditions within the country could deteriorate over time as internal dissent becomes more difficult to manage and worsening economic conditions stoke social unrest. Maduro is likely to maintain Petrocaribe, but in the medium term, domestic fiscal constraints may well force him to reduce foreign aid, since among the spending commitments of state-run oil firm and government piggy bank PDVSA, help for foreign governments is the easiest area to cut. Maduro will have to care more about support at home than friends abroad.
Venezuela is currently giving away about one-third of its oil production at below-market prices, including as part of the Petrocaribe program. At today's prices, the volumes that go to Petrocaribe partners amount to more than $6 billion in lost revenue -- about 2 percent of Venezuela's total GDP.
The new president will probably prioritize aid to Cuba, since the Castro brothers are strategic allies and high-profile friends who likely played a role in vetting him for the presidency. Maintaining strong relations with the Castro regime is also a means for Maduro to protect his revolutionary credentials as he works to establish himself as Chávez's legitimate political heir.
But for other Petrocaribe countries, aid reduction will likely be substantial. The Dominican Republic and Nicaragua would likely face the toughest economic challenges, forcing policymakers to make sharp policy adjustments. Reduction or elimination of Petrocaribe financing would put the DR's Danilo Medina in an especially tight spot. Given the size of its economy and its access to international financial markets, the Dominican Republic is better placed than Cuba or Nicaragua to weather the storm, but Medina is already looking for new sources of state revenue.
Cuts to Petrocaribe would also be bad news for Daniel Ortega's government in Nicaragua. Some estimates have Venezuelan support -- in the form of direct loans to Ortega, energy projects, and oil -- at about $500-600 million a year. That's 7-8 percent of Nicaragua's GDP. Petrocaribe has allowed Ortega to subsidize electricity rates and public transportation, boost public sector wages, spend on infrastructure improvements, and enhance food security. A significant cut to Petrocaribe might even persuade Ortega to make new friends in Washington.
These are a few of the reasons why there will be so much international interest in Venezuela's election -- and in what comes next.
Risa Grais-Targow and Heather Berkman are analysts in Eurasia Group's Latin America practice.
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With a surprising and inconclusive election result and no clear route to a government almost two weeks later, Italian politics appear to have returned to what passes for normalcy there. Despite the near-term uncertainty, three things do seem clear. First, new elections are likely to take place between six months and a year from now. Second, voters are fed up with tax-heavy fiscal consolidation and structural reforms. Third, Italians have had their fill of a corrupt and gerontocratic political class, as demonstrated by the success of comedian Beppe Grillo's anti-party, anti-corruption Five Star Movement (M5S).
Despite the movement's negative portrayal in the media, Grillo's M5S could be the breath of fresh air that Italian politics badly needs if -- and it's a big if -- it can make a constructive contribution to dialog in the parliament. It is true that M5S's feud with the domestic media, crude skewering of established politicians, and potentially disastrous economic views have raised concerns from foreign policymakers and market participants. For example, Grillo personally supports a referendum on euro membership and has discussed restructuring the public debt or delaying interest payments. Officially, the Five Star Movement also hopes to roll-back the Biagi law, a liberalizing labor market reform, and renationalize the telephone network, among other economically questionable proposals.
But the movement has also been treated unfairly by international commentators. Comparisons to populist, far-right groups are just wrong. The M5S is not racist, violent, nationalist, or anti-democratic. Moreover, some of its economic proposals, especially where competition policy and reducing the state bureaucracy are concerned, are sensible. And while M5S's newly-elected parliamentarians may be inexperienced, they are also younger, more educated, and include more women than most other parties. These qualities make the movement more representative of modern Italy than many of their opponents.
But in the near-term, Italian politics will be dominated by efforts to form a government. Pier Luigi Bersani, the leader of the "Italy Common Good" coalition, gets the first crack at forming a cabinet thanks to his coalition's majority in the lower house (it failed to secure a senate majority, though). Bersani hopes to persuade the "Grillini" to support an eight point legislative plan, though Grillo has only agreed to evaluate each bill independently. The markets and the Italian public seem to understand that economic reforms are on hold for now, but both are hoping for political reforms.
Should Grillo allow political reform to move forward -- especially to the flawed electoral system -- the public will likely reward the Five Star Movement when Italy returns to the polls. (A new president must first be chosen, while electoral reform and cutting the number of parliamentarians and their salaries, as Bersani has proposed, would take several months.) A more cynical electoral strategy would be to hamstring any attempt at change, perhaps forcing Bersani to turn to Berlusconi and the center-right for a grand coalition. That strategy may allow the Grillini to capitalize on public disgust when new elections are called, but it is unclear how voters will respond if M5S adopts such an intransigent approach.
Whatever M5S does, even greater uncertainty will probably surround the next elections. Inaccurate polling, and perhaps a new voting system, will again make seat counts difficult to predict. And because markets will demand more than just political housekeeping, the stakes are almost certain to be higher. But the election could also provide an opportunity to finally move on from the dysfunctional, bipolar politics of the Second Republic, and that would be no small achievement.
Peter Ceretti is a researcher with Eurasia Group's Europe practice
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By Gemma Ferst
The lack of global leadership, what we at Eurasia Group call the G-Zero, has become a common refrain among international thinkers. But while others wring their hands, over in his Ak Orda (White Horde) palace in windswept Astana, Kazakhstan's President Nursultan Nazarbayev is planning to do something about it.
In February, he launched G-Global: a bid to hatch a new world order through the exchange of ideas. Styled as an "electronic Bretton Woods," G-Global will disseminate a plan for global reform in May. On hand to provide intellectual firepower is the Eurasian Economic Club, which, bringing together top economists from Tajikistan to Moldova, has already produced a draft.
The road to Utopia could be long, though. Although G-Global boasts 10,000 members from 28 countries, the vast majority (more than 40,000) of the posts on its forum emanate from a single doctoral candidate at Irkutsk State Technical University, formerly the Siberian Mining Institute. None of the 543 participants who signed up in the last month has so far weighed in, suggesting that global traction may still be a ways off.
Nazarbayev, a former metallurgist who has ruled his oil-rich country since Soviet times, has long been something of a blue-sky thinker. The absence of criticism from his citizenry, combined with plenty of petrodollars, has fed an apparently genuine belief that it is his destiny to solve more than just Kazakhstan's problems. Previous schemes include a new, as yet unrealized global currency dubbed the Akmetal and an annual Congress of World Religions in Astana. (Nazarbayev commissioned British architect Norman Foster to design the $58 million Palace of Peace and Reconciliation -- a pyramid housing an opera house in its basement -- just to host the event.) He also came up with the idea of a Eurasian Union, well before Putin took it up again last year.
Nazarbayev cares greatly about how outsiders perceive him. He spends huge sums on Western public relations campaigns and has taken on Tony Blair as an adviser. Indeed, at 71, he is hoping to establish his legacy as an international statesman, peace-builder, and possible Nobel Peace Prize winner.
What G-Global really shows us, though, is what happens when authoritarian states try to innovate. Billed as a platform for free-wheeling discussion, G-Global comes with a code of conduct that is both granular and draconian. Contributors are forbidden to "maliciously non-adhere to the rules of the Russian language," for example, and are instructed to exclude any "political content" from their posts -- a practice that would seem to put the kibosh on serious attempts at revamping global governance.
This same autocratic reflex will hamper Kazakhstan's bid to become one of the world's most competitive economies by 2015. Nazarbayev refers to innovation as a "gigantic leap of the Kazakhstani snow leopard into the future" and has ordered the country's state-owned firms to modernize. But these firms -- even the start-ups -- are ruled with a centralized iron fist. And the government's response to unrest, notably the deadly violence in Zhanaozen last December, is always to tighten the leash.
With G-Global, Nazarbayev wants to "radically widen the number of participants in seeking anti-crisis solutions for the world." But he won't countenance a similar widening of Kazakhstan's own political process (letting the opposition stand in elections would be a start), which is why this particular snow leopard won't be influencing global leaders any time soon.
Gemma Ferst is an analyst in Eurasia Group's Eurasia practice.
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By Antonio Barroso
With the survival of "Merkozy" at stake, German Chancellor Angela Merkel has inserted herself into the French presidential election on behalf of her eurozone partner, President Nicolas Sarkozy. It's not just because a Francois Hollande victory would make finding a new pithy nickname for the German-French duopoly difficult (though it would be a challenge -- "Hollmerk?" "Merkande?") Or because it has become trendy for like-minded political figures to support each other in races across national boundaries within the EU.
Merkel views the preservation of her partnership with Sarkozy as an important element in the timely resolution of the eurozone crisis, despite their rocky start, numerous disagreements, and natural rivalry. The devil that Merkel now knows well, and has spent considerable capital cultivating, is preferable to the devil she doesn't know, and can only speculate about -- a socialist who, while pro-European, has bashed the financial sector, disparaged austerity, and promised to maintain social spending. There are too many uncertainties in a Hollande presidency for Merkel to sit idly by in Berlin as Sarkozy continues to trail significantly in the polls ahead of the April 22 first-round vote.
That's why Merkel has actively stumped for Sarkozy, tying German conservatism to its French counterpart. The alliance between the German and French leaders is not just a personal bond, forged through the crucible of the eurozone crisis. Merkel believes she now has a partner in Sarkozy who shares her beliefs about the currency bloc -- and will push those interests (which also happen to be Germany's interests) in Brussels. After all of the painstaking negotiations and one-on-one meetings, she's not about to start all over again.
Hollande's political party, his campaign statements, and the fragility of the eurozone have many observers worried that a Hollande presidency would put France -- and the eurozone -- into greater danger. Some view Merkel's visible and vocal support of Sarkozy as validation of this viewpoint. But there are a few reasons why a Merkel-Hollande partnership would not be the market-rattling, eurozone-damaging outcome that many predict.
As wary as Hollande might be about austerity, or about the German model, his ability to take the EU in his ideal policy direction is limited. Why? Because the markets are on Merkel's side. Hollande only has so much room to maneuver before the markets punish France with higher borrowing costs, which would in turn threaten the integrity of the eurozone's bailout fund and its continuing efforts to prevent contagion. The pro-European Hollande does not want to preside over a new ugly chapter in the eurozone crisis.
It's also important to distinguish between what is campaign fodder and how Hollande would govern. Yes, Hollande has criticized the fiscal pact that Sarkozy, along with 24 other European leaders, agreed to in order to harmonize budgetary policies in member nations. But when Sarkozy is making his ability to lead France during an economic crisis a central campaign issue, Hollande has to find a way to distinguish himself. Hollande also can't proclaim the virtues of austerity -- and what is inherently a conservative fiscal policy -- as the leader of France's socialist party. Under the pressure of governing one of the eurozone's two major players, Hollande's policies are unlikely to differ drastically from Sarkozy's.
So is Merkel expending too much energy to stump for her favored candidate? Not necessarily. Hollande's socialist leanings, his reluctance to alienate his core voters, and his lack of a personal relationship with Merkel all suggest that decision-making between the two powers, and the eurozone as a whole, would be slower with Hollande as president. These ingredients are also the makings of a difficult personal relationship between the two leaders. And if there is one thing that markets have taught the eurozone, it is that dawdling in decision-making can be nearly as painful as making the wrong decision. The importance of Merkel's ability to pick up the phone, call Paris, and hear a familiar voice on the other end of the line should not be discounted. She doesn't have the luxury of time to cultivate another ally in the Elysee Palace.
Antonio Barroso is an analyst in Eurasia Group's Europe practice.
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By David F. Gordon
Efforts to resolve the European debt crisis are dominating the G-20 summit, with European leaders scheduling emergency meetings late into the night in a desperate attempt to prevent the situation from worsening. Despite last week's announcement that there was a plan to address the crisis, however, Europe's "muddle through" approach is likely to endure. Moves toward a true fiscal union will be elusive, leaving Europe with several more years of poor economic performance and an increasingly inward-oriented focus. Indeed, in the next few years, Europe is poised to become a less capable and less willing partner of the U.S, and reduced U.S-Europe coordination will hasten the power shift from the West to emerging markets.
Europe's crisis has thrust the decades-long process of regional integration into reverse: The crisis will forge closer ties among eurozone countries, but at the expense of broad European unity. The key element of European integration will no longer be the 27 members of the EU, but the 17-or fewer-countries of the European Monetary Union (EMU). And because EMU countries tend to follow less liberal investment, trade, and labor policies than EU members outside the eurozone, this shift means that Europe could begin to close its doors, with regional trade increasingly limited to the eurozone. The U.S and the EU have the largest bilateral trade relationship in the world; a downsizing of that relationship would have ripple effects across the still-recovering U.S. economy.
Likewise, the push for austerity will squeeze European military budgets and reduce European leaders' inclination to engage militarily abroad. Military interoperability between the U.S. and its European allies will wane, and NATO's New Strategic Concept, adopted with much fanfare less than a year ago, will fall to the wayside. This year's intervention in Libya, in which the U.S. ostensibly maintained a supporting rather than leading role, will therefore prove to be the exception. (Even that operation underscored Europe's decreasing ability to project force, as NATO equipment and technology shortages necessitated direct U.S. involvement in military action.)
Strategically, Europe's inward orientation will stymie transatlantic cooperation vis-à-vis China and other emerging powers. Nowhere is this better illustrated than in the speculation about a Chinese rescue of the eurozone: though nothing is likely this week, China may eventually offer limited assistance, either bilaterally or through a multilateral group centered on the BRICs or the G-20, and either approach would strengthen Beijing's hand. A bilateral deal would include concessions to Beijing, such as the IMF revising its voting structure to give large, emerging markets more clout or Europe granting China market economy status. And a multilateral approach would allow Beijing to partner with countries that share its desire to alter the international economic order. These alliances would pay dividends for Beijing in the future, as China and its counterparts bargain for more representation in international economic institutions. But for the U.S., such an outcome would challenge its efforts to incorporate developing economies into the political, economic, and security architecture that has underpinned the international system since World War II. And failure to do so risks friction and even upheaval as the world shifts from a unipolar to a new global order -- one in which the U.S. is only first among equals.
David F. Gordon is Eurasia Group's head of research and director of global macro analysis. This post was adapted from his recent testimony before the Senate Foreign Relations Committee.
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By Michal Meidan
Most Chinese are growing old before getting rich. The country's census results, published last week, show that of the country's 1.4 billion people, the number of those over the age of 60 ballooned by more than the population of Spain in a decade. Thanks to China's one-child policy, children under the age of 14 make up less than one-sixth of the population. This leaves the country's modestly paid working class to support two parents and four grandparents each, and taking care of one's elders can be dauntingly expensive for the average worker. The small upper class, meanwhile, is splurging on mansions. For a regime that bases its political legitimacy on economic wellbeing, a GINI coefficient nearing 0.5 (which puts China's income inequality on par with that of countries such as Sri Lanka) is a ticking time bomb.
Despite the nail-biting in Beijing about the potential consequences of inequality, the income gap is set to persist, partly because wealth is concentrated in the hands of the political elite. Many of China's new millionaires are the offspring of top officials, and other moguls have emerged from the ranks of state-owned firms. Since the beginning of the global financial crisis, the state has only tightened its grip on economic power. Private entrepreneurship is shackled, and the road to riches is closed to many. Young college graduates often earn just a fraction more than migrant workers do and have little hope of buying property, let alone the Ferraris they see in the streets of Shanghai.
So how should Beijing respond to its people's expectations and to the frustration that inevitably arises when dreams go unrealized? China's top leadership has yet to reconcile Maoist notions of equality with Deng Xiaoping's notion that "getting rich is glorious." In the meantime, Beijing will shift its emphasis from growth to development and do its best to make households richer. It is spending more heavily on welfare schemes and social safety nets and is mandating wage hikes across the country -- all of which will give workers a little more pocket money and ease the burden of supporting relatives. Officials have also begun introducing curious measures to prevent the less fortunate from realizing their increasingly less fortunate circumstances, including banning "lavishness" in advertising and restricting the size of tombstones.
This will keep resentment at bay in the near term, but social tensions are bound to rise as China muddles through its ideological crisis. To prevent them from bubbling over, Beijing will have to forge some sort of compromise: both expanding the Chinese Dream to include more people and broadening the sources of its own legitimacy.
Michal Meidan is an analyst in Eurasia Group's Asia practice.
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By Kim Iskyan
The Russian government says that it wants to turn Moscow into an international financial center. But such hopes face many obstacles -- not the least of which are the government's own efforts to encourage the development of national champion banks.
In March, the government announced the creation of a high-profile advisory committee consisting of the heads of a number of powerhouse global banks to advise President Dmitry Medvedev on the project. This will bolster the series of working groups supporting the initiative headed by Alexander Voloshin, a savvy government insider with a reputation for competency. The government also announced it would create a $10 billion investment fund that will be managed by state-controlled development bank Vnesheconombank.
The needed regulatory and market infrastructure is also progressing. Two key regulatory bodies are merging, allowing for a more efficient oversight. Efforts to require large private companies to adopt international financial reporting and accounting standards should substantially improve transparency. Also, the pending purchase of RTS, Russia's second-largest trading floor, by the MICEX exchange would result in a larger Russian exchange with greater visibility and credibility.
Yet obstacles to such a goal will probably limit Moscow's future role in global financial markets. Among the chief short-term roadblocks is the crowding out caused by the ongoing privatization program that will primarily raise funds on the London and New York markets rather than Moscow's. That decision of course also reflects that lack of depth in local capital markets. On another front, domestic pension reform would mark a big step toward developing more local expertise but it's been delayed for years and appears unlikely to be placed on the agenda well until after the 2012 presidential election.
Another factor is the rise of state-owned national champion banks Sberbank and VTB. Moscow's efforts will further reduce the level of competition throughout the banking sector and make the market less attractive to private (including foreign) banks. The late April news that HSBC is pulling out of retail operations in Russia underscores this dynamic.
There are also problems with the broader investment environment, ranging from endemic corruption and weak rule of law to a stifling bureaucracy and personalized politics. Progress on these fronts is critical if Moscow is to make any real headway in establishing itself as an international financial center. Russia's investment environment will benefit from some of the changes, but it remains unclear whether the government will be willing to launch the comprehensive reform program needed to address the economy's underlying weakness.
Kim Iskyan is a director with Eurasia Group's Eurasia practice.
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By Ian Bremmer and David Gordon
2010 was a difficult year for Europe, and things won't get easier in 2011. The eurozone will remain intact, but there's a serious risk that the debt crisis will become increasingly unmanageable this year. As peripheral countries struggle to implement structural reforms, the politics of austerity will put additional public pressure on supporters of the EU project in core countries like Germany and France.
In recent weeks, the EU has done little to allay investors' fears about the solvency of both sovereigns and banking systems in a number of peripheral eurozone countries. Key questions on the nature and timing of future financial bailouts remain unanswered, and important potential remedies, like increasing the European Financial Stability Facility (EFSF) and introducing new eurozone bonds, have been taken off the table, at least for now.
At the moment, the core countries, led by Germany, are committed to the euro and the European integration project, even as they avoid efforts to find systemic solutions to the crisis. In Spain and Portugal, governments are moving to fast-track fiscal consolidation and structural reform in an effort to preempt market pressures. While markets remain skeptical, the hope in Brussels, Berlin, and Paris is that this is just the beginning of a sustained rebalancing that will help stabilize the eurozone. In this view, the European economic crisis is the catalyst needed to restore policy convergence within the eurozone and to enforce peripheral Europe's compliance with the "Lisbon agenda" of labor and product market reform. Yet the idea that the EU, the ECB, and national governments can rapidly remake fiscal patterns of peripheral Europe -- let alone their labor markets and regulatory regimes -- strains credulity. That's especially true given the weak economic forecast for these countries and their inability to undertake currency devaluations.
Ireland, Greece, Portugal, and Spain have all taken impressive first steps on the fiscal side, but policy sustainability remains an open question. Politicians in each of these governments will have a hard time enforcing cuts to wages and entitlements that erode their nations' standards of living. Structural reforms like privatization and trade union regulation will threaten well-organized groups, which will mobilize in opposition. The result will not be explicit rejection of these programs, let alone an exodus from the eurozone. Peripheral Europe is more likely to take a page from developing countries in how they manage relations with the International Monetary Fund and World Bank -- with a lot of fudging and passive opting out of important parts of their plans.
The political challenges facing reform in the periphery will make it more difficult for defenders of financial bailouts within core countries, and we're likely to see new political fissures on this issue, especially in Germany. This problem will heighten the sense of broader political conflict on the continent, increase policy coordination risk (especially between Berlin and Paris), and undermine market confidence in the EU's ability to sort out the crisis.
All of this leads to the real danger: that the eurozone countries big enough to matter in global finance -- namely, Spain and Italy -- will find it increasingly difficult to borrow at rates that are financially sustainable. If that happens, the chances of a systemic crisis will grow dramatically.
On Wednesday, we'll look at no. 3 on our list of Top Risks for 2011: the geopolitics of cybersecurity.
Ian Bremmer is president of Eurasia Group. David Gordon is the firm's head of research.
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By Eurasia Group's Europe practice
It hasn't been an easy year for Europe, and 2011 doesn't look much better. Hopes that a rescue package for Ireland would halt the debt crisis contagion have been dashed -- Portugal, Spain, Italy, and Belgium already face market pressure, and if the situation deteriorates, the European Union and IMF are likely to push for some form of structured assistance to Portugal. It may not end there. Italy and Belgium could be the next to face bond market problems, and non-eurozone countries like Hungary and Romania could face growing scrutiny about their finances. Eurozone watchers are already questioning the ability and willingness of core eurozone countries (particularly Germany) to spend additional bailout money beyond the current European Financial Stability Facility (EFSF) commitments that would be required. Such concerns raise both existential and tactical questions about the longer-term viability of the euro.
If countries abandon the euro, everybody loses. That scenario isn't a significant risk at this point, but some countries face the real prospect of restructuring and/or default, and they'll be much poorer following internal devaluation and/or a bout of domestic deflation. The next few years will be particularly tough for Greece, Ireland, Portugal, Spain, and Italy. In broader terms, there's a clear North-South divide emerging. Southern countries, in both Western and Eastern Europe, face a variety of challenges ranging from fiscal policy to macroeconomic rebalancing and competitiveness that will be extremely difficult to overcome in the short term. We've already seen social unrest in several countries as a result, and we'll see more in 2011.
In the broadest sense, the process of EU convergence has been thrown into reverse. For capital markets, this means that yields on bonds issued by non-core members are no longer converging to the lower rates that markets give core members. The widening spreads are obvious not only in peripheral eurozone countries like Greece, Ireland, Portugal, and Spain, but are also showing up among non-eurozone EU member states like Hungary, Romania, and Bulgaria. This divergence comes from two sources: a decline in the belief that the European Union will provide universal bailouts within the eurozone, and doubts among market players about the strength of political enthusiasm in Eastern Europe (where bond spreads have stabilized for now) for adopting the euro.
In 2011, the idea of an ever-closer union will provoke deeper skepticism than we've seen in years, but the European Union has an opportunity to use this crisis to build support for the sorts of reform that only crisis can make possible. Policymakers are working along three tracks. First, they want to establish a permanent crisis resolution mechanism -- an extension of the EFSF that includes some form of burden sharing with private investors. The second element would consist of fiscal reforms that actually enforce growth and stability pact targets that have been ignored in several capitals for many years. The third part would involve macroeconomic rebalancing, with a focus on labor market and judicial reforms to improve economic competitiveness. But during the European Council summit in mid-December, leaders made only limited commitments to take these issues head on, and more talks will be necessary in coming months. They did agree, however, on a permanent mechanism to help eurozone nations crippled by debts. Market players need a lot more detail on how the crisis mechanism will work, but it's a step in the right direction. Monitoring and enforcing fiscal targets will be more straightforward, with some enhanced penalties and European Commission oversight rules.
Then there's the need to make several European economies much more competitive. Belief in the ability of the European Union to force true macroeconomic rebalancing requires faith in the political will of both Brussels and core eurozone countries to push through systemic changes that will generate lots of pain. Selling those changes, and persuading crisis-weary publics to accept that the pain will last well beyond 2011, will prove the biggest challenge of all.
This post was written by analysts in Eurasia Group's Europe practice.
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By Henry Hoyle
Last week, Jim O'Neill, head of Goldman Sachs Asset Management and a longtime China expert, made the bold claim that China's allowing the yuan to appreciate is part of a "grand bargain" with the United States to win support for enlarging Beijing's clout at the International Monetary Fund (IMF). (The yuan has gained about 3 percent against the dollar since June.) O'Neill's assertion echoes others who have argued that IMF governance reform should be made contingent on concessions from China to revalue its currency. The theory may be entertaining to discuss, but there's no real evidence of a quid-pro-quo here.
The United States has long supported giving China more power at the IMF -- even in the face of the yuan's painfully slow pace of revaluation. The United States backed China's bid to expand its influence at the IMF as early as 2006, and then did so again at the G-20 summits in 2009, when China was refusing to let its currency budge.
If a deal was indeed struck, as O'Neill claims, it raises a couple of questions. First, why would China abandon its longstanding refusal to negotiate the value of its currency? And second, why would Washington believe Beijing even if the Chinese promised to let the yuan rise? China has strengthened its currency this year only when foreign pressure was nearly over the boiling point, and even reversed appreciation when international attention temporarily dwindled over the summer.
To O'Neill's credit, the concept of a "grand bargain" did factor into the original U.S. rationale for backing IMF reform that favored China. According to what a senior Treasury Department official said in 2006, granting China more voting rights at the IMF would encourage Beijing to abide by international rules and accept best economic practices. But for the past few years, Chinese policymakers seem to have operated under the assumption that once China's economy grew large enough, the West would support the expansion of China's IMF voting rights regardless of whether they made concessions. In light of the IMF's recent decision to approve China as its third most powerful member, that assumption appears to have been correct.
If, despite all this evidence, O'Neill is still right, one thing is certain: The West certainly didn't strike a very good deal. China secured its expanded voting rights in the IMF without falling into line with international norms on currency rates, export subsidies, or market access. Calling the G-20 deal a grand bargain puts too positive a spin on it. We might as well call it a giveaway.Henry Hoyle is an associate in Eurasia Group's Asia practice.
By Preston Keat
There is a new optimism in the Eurozone, but it may be masking some serious risks.
In a moment of crisis this spring, representatives of the 16 Eurozone governments came together to take dramatic action. Greece faced imminent financial collapse. Spain, Portugal, and Italy looked to be next in line. The Eurozone committed substantial sums of money, markets stabilized, and disaster was averted. Yet, Europe can no longer ignore the reality that the days of slow but steady Eurozone "convergence" are finished -- possibly forever.
Gone are the days when traders could ignore big differences in Greek and German economic policies as they invest in the two countries' sovereign debt. Prospective Eurozone members from Eastern Europe were once treated with little differentiation, despite wide variation in the credibility and transparency of their policymaking. The rule was for lower costs of capital for current members and Eurozone hopefuls alike, regulatory and legal integration, and diminishing attention to differences in national-level economic policymaking.
In the new Europe, the consensus favors belt-tightening. Governments must spend less money, collect more revenue, and guard against inflation. If governments fall of the wagon, it is feared, Europe's single currency will again be in serious trouble.
THOMAS LOHNES/AFP/Getty Images
By David Bender
Remember when Iraq was all about the oil?
Bush administration officials predicted that a post-war spike in Iraq's oil production would pay for both the conflict and ease the country's transition to democracy. Anti-war protesters countered that the war itself was little more than an oil grab. Now that the American combat mission is officially over, where is all that oil, and how will it change Iraq and the world?
It seemed for years that violent chaos inside Iraq made a big increase in oil production entirely unrealistic; but now there are growing signs that oil project work could begin on several fields in the south over the next six months. If these projects move ahead, over the next decade, Iraq could begin to contribute enough production to significantly influence the global oil market, providing enough supply to undermine assumptions that energy demand from emerging Asia and increasing production costs will squeeze energy markets and add serious upward pressure on prices in the mid 2010s.
Iraq is now producing about 2.4 million barrels per day. The 12 contracts signed with some of the world's largest oil companies fuel hopes that Iraq can increase production nearly fivefold by 2020. That target is unrealistic, but even the likelier tripling of production levels will have important implications for the global economy and raise interesting questions about regional political dynamics. For the moment, Saudi Arabia is the only producer with enough spare capacity to single-handedly move prices. How will the Saudis respond if Iraq can produce enough oil to usurp some of that market power? How will Iran react if a surge in Iraqi production drives down oil prices, depriving Tehran of badly needed revenue? Globally, will Iraqi oil power Chinese and Indian growth? Will it kill the electric car? Iraqi oil production increases will have widespread effects-if they happen.
But Iraq will be a politically volatile and potentially unstable place to do business for the foreseeable future, and a spike in the country's oil production is anything but a sure thing. Nearly six months after parliamentary elections, U.S. combat troops leave behind a country without a government. Vote winner Iyad Allawi, incumbent Prime Minister Nouri al Maliki, an array of Shia sectarian leaders (including firebrand cleric Muqtada al Sadr), and the Kurds remain locked in a seemingly endless battle of diplomatic nerves, holding fruitless rounds of negotiations, forming and breaking alliances, and making declarations of principle with little bearing on political realities.
ALI YUSSEF/AFP/Getty Images
By Dan Alamariu
The results of recent stress tests of European banks were all but a foregone conclusion. The assumptions on which the tests were built were not severe enough to potentially undermine the still-recovering EU financial sector. The similarity to the stress tests that were performed by U.S. authorities in spring of 2009, when the top 19 U.S. financial institutions were tested, are striking: In neither case did the tests assume the (not-all-that-unlikely) worst-case scenario.
Why bother with a stress-test then? This question raises a quandary that goes to the heart of government responses to the financial and economic crisis: How do we balance the need for stability that restores near-term confidence with the need for increased transparency to ensure it doesn't happen again? There's no easy answer, but it's a crucial part of all the fiscal and regulatory responses to the 2008-2009 financial meltdown. In choosing between the policies emphasizing stability and those leading to transparency, which over the short-term can be mutually exclusive, governments face a tragic choice worthy of Sophocles: neither option is likely to produce a happy outcome in the next couple of years, and neither is sure to solve the long-term problem. Both contain tragic flaws.
BORIS ROESSLER/AFP/Getty Images
By Nicholas Consonery
Over the weekend, while in Busan, Korea, U.S. Treasury Secretary Tim Geithner said Beijing should resume "reform of their exchange rate mechanism." This brief comment was just a hint at the deluge of pressure China will face from the U.S. over currency policy in coming months unless the Chinese leadership allows the RMB to start appreciating against the dollar. But these days, Beijing looks less and less willing to alter course.
The RMB has been fixed against the dollar since the beginning of the financial crisis in July 2008. A month ago, Beijing looked like it was on the cusp of revaluing the RMB and allowing more upward momentum against the dollar -- mostly to assuage tension over currency policy with the United States.
But the debt crisis in Europe is weakening support in the Chinese government for changes in currency policy because the value of the RMB has been anything but stagnant against the euro in recent weeks. As concerns about European fiscal solvency have stewed in the markets, the dollar has appreciated significantly against the euro and other major currencies - and dragged the RMB along with it. Since January of this year, the RMB has actually appreciated by 20 percent against the euro-upward momentum that has accelerated significantly since May when concerns about solvency in Greece and Portugal wreaked havoc on markets. On Friday, June 4, the RMB appreciated by 1.58 percent against the euro in just that one trading day.
This rapid upward movement in the RMB against the euro presents a major concern for the Chinese economy. Why? Because the euro zone is China's single biggest export market, accounting for 19.7 percent of Chinese exports in 2009. In recent weeks, top officials at China's commerce ministry have publicly called for continued support for export-focused industries (which would include the currency peg) as the crisis in Europe plays out. Believers in this argument are now pointing to May's decline in China's purchasing manufacturer's index, which measures industrial activity, as early proof that Europe's troubles are already bleeding over into Chinese growth. Meanwhile, Chinese exporters and the local governments that support them report weaker confidence in the prospects for euro value and for the broader European economy.
But other policymakers in Beijing seem more optimistic. Among those is Zhou Xiaochuan, the central bank governor, who argued alongside Secretary Geithner that the euro crisis' impact on the Chinese economy "should not be very great." This may be wishful thinking, predicated on the belief that European officials can use enough fiscal alchemy to convince forex traders that the euro isn't on a set course to parity with the dollar this year. At the same time, Zhou might be trying to signal his continued support for pressing forward with reform to the RMB exchange rate mechanism now, despite Europe's woes.
It will fall to the top leadership in the Chinese Communist Party structure -- probably President Hu and Premier Wen themselves -- to settle this debate and make the final decision about what to do with the RMB. But if history is any guide, Beijing is steadfastly opposed to any kind of "shock therapy" for the Chinese economy. And a 20 percent appreciation of the RMB against the euro in just five months seems shocking enough to delay any more upward movement in the value of the Chinese currency for now.
There are several fascinating elections due this year. Next month, we can look forward to Britain's most unpredictable outcome in 100 years. In Poland, former Prime Minister Jaroslaw Kaczynski has become a presidential candidate in hopes of succeeding his twin brother Lech, killed in a plane crash earlier this month. Japan's ruling DPJ faces a referendum on its first turbulent months in power with upper house elections this summer. In November, recession-weary Americans will go to the polls to elect a new congress.
With all that going on, you probably haven't thought much about next month's local elections in North Rhine-Westphalia, Germany's largest state. Eager to institutionalize a post-bailout era of greater fiscal discipline, the German government is preparing to push for a major revision of eurozone rules in the form of a new European Union treaty. The aim is to build momentum behind a drive for fiscal consolidation and greater powers to enforce rules across the currency union.
But it's hard to imagine that Chancellor Angela Merkel's government will get what it wants. Irreconcilable differences remain among key European states, and Germany doesn't have the political power it held a generation ago in the run-up to introduction of the euro. Today's union is much larger, and the perceived benefits of convergence are worth less. The contentious debate over a new treaty will unfold just as the battle is heating up to replace Jean-Claude Trichet as president of Europe's Central Bank.
The immediate concern is that Standard & Poor's lowered Greece's debt rating to junk on Tuesday and Portugal by two steps. The big longer-term worry for Europe is that politicians locked into tough deflationary programs (in Greece and beyond) will take the once-taboo step of pushing for debt restructuring. We're not talking about the break-up of the eurozone, no matter how much apocalyptic rhetoric we hear in days to come or how many pundits write articles this fall with titles like "Who killed Europe?" But the less dramatic risks for European fiscal policy are plenty serious.
That's where Germany's local elections come in. The balloting in North Rhine-Westphalia, home to more than 20 percent of Germany's citizens, will provide a real test of Angela Merkel's center-right government. A bad result would jeopardize Germany's shot at tax reform. More to the point, it would weaken the entire eurozone by undermining support for fiscal discipline at the heart of Europe.
A return of the German left, even a modest one, will generate much more expansionary policy than we saw during the grand coalition period between 2005 and 2009. That will create stronger institutional support for German labor demands, driving a rebalancing within the eurozone as German labor costs begin to rise. That will undermine European competitiveness at a delicate moment in the union's recovery from recession. Over the longer term, it's hard to imagine Europe's fiscal woes improving in that environment. That's why I believe strongly in the eurozone, but not in a strong eurozone.
Ian Bremmer is president of Eurasia Group and author of The End of the Free Market: Who Wins the War Between States and Corporations? (Portfolio, May 2010)
AXEL SCHMIDT/AFP/Getty Images
I'm seeing a lot of Russians in Davos this year, but surprisingly little Russia. It's hard to say if it's a conscious decision by the Russian government, but if so, it strikes me as a pretty sound strategy. After all, Russia as a topic generally comes across as a negative in global circles--revisionist geopolitics, resource nationalism, and strongly authoritarian (albeit charismatic, in a fashion) domestic leadership. Instead, there are a healthy number of Russian executives going about their business, presenting on panels along with colleagues from other countries, and generally integrating well. It's probably their best Davos in a good long while.
The Russians have nothing on the Japanese execs, who are here in serious force. Though absolutely none of whom are actually talking about Japan. Indeed, the only attendee I could find giving a bullish Japan story is Pepsi CEO Indra Nooyi, who apparently is making money there cans over fist. For everyone else, it's a story of a dwindling population and flat consumption, but world-class technology, strong regulatory structure, and top-notch management. Japan's model apparently is to become a bigger Singapore.
Speaking of Singapore, a sad piece of trivia I just heard: after lots of lobbying and prodding, an Armenian friend of mine (full disclosure: my mum's also Armenian) recently got Singaporean minister and mentor Lee Kuan Yew to spend three days in Armenia. But the Armenian government initially didn't want to meet with him because they didn't know who he was. Land-locked, no resources to speak of, and apparently they don't read the paper. Oy.
Ian Bremmer will be blogging from Davos this week sending reports and commentary from inside the World Economic Forum.
PIERRE VERDY/AFP/Getty Images
Thus far, the Obama administration isn't making much of a showing. Undersecretary of State Bob Hormats did a strong job on yesterday's U.S.-China panel. But there's little coordination and not much of a message. If Secretary of State Clinton is too busy, why not send Vice President Biden? Combined with perfunctory foreign policy mention in the State of the Union, I'd suspect it's a feeling that anything but domestic issues isn't going to play well politically. That's not the strategy I'd be going with.
So for the American delegation, it's the U.S. private sector that's leading the charge here. And the omnipresent Barney Frank -- who yesterday told a private industry group to stop listening to what congress says, and look at actual policies ... do they have anything to complain about? Heads nod reasonably sagely.
Meanwhile, criticism of imminent political explosion grows as the nights wear on. Rogue economist/historian/documentarian Niall Ferguson, distinctly unshaven (proffered excuse--he forgot his razor on his flight from Delhi), wagered me $100 that the United States would have a new Secretary of Treasury by June 1st this year. Wager accepted. Howard Lutnick of Cantor Fitzgerald said he'd go $100 for Sept. 1. The bankers are always pushing it.
Ian Bremmer will be blogging from Davos this week sending reports and commentary from inside the World Economic Forum.
ERIC FEFERBERG / AFP / Getty Images
There's a lot of buzz about French President Sarkozy's speech last night, more than Obama's state of the union address. In part because we were sleeping, and in part because while Obama gives a better speech, Sarkozy is a more effective populist.
It's no particular trick to go after the bankers; it's almost sport this year, but folks don't really have their heart in it.
Not so the French president. He went after the bankers, the dollar, capitalism with righteous indignation. Obama goes through the motions, but he's still all about hope and the vision thing (after all, he may need to tack back in a few months). Sarkozy wants to channel all these angry people.
To be fair, Davos folks aren't all that angry. Something like two people applauded when Sarkozy said the world had to put morality back into capitalism. There were all sorts of reasons for that (lack of) reaction -- antipathy, profound skepticism, malaise, jetlag. But it wasn't a message that was going to rile the Davos folks. Having said that, unless you're Klaus Schwab (or, nowadays, Bill Clinton), most of these speeches are for the home team.
* * *
Just overhead the Davos quote of the hour. South African President Jacob Zuma: "We must respect the culture of others. Polygamy is my culture and i treat my wives completely equal." Call it a wives' tale. Incidentally, there's a very large South African delegation accompanying the South African president, but I've only seen men.
Ian Bremmer will be blogging from Davos this week sending reports and commentary from inside the World Economic Forum.
PIERRE VERDY/AFP/Getty Images
Decided against the Bill Clinton event last night -- primarily in the interests of sleep. Due apologies. He's scheduled at a Coca Cola reception tonight, so I'll probably catch him there.
I did spend some quality time with Andrew Ross Sorkin. We were typing away on dueling computers, both generally unaware of each other ... until I finished up and looked over to my left. Lovely fellow. Surprisingly unselfpossessed given the extraordinary success of his recent book, Too Big to Fail.
We don't know each other well, but I particularly wanted to discuss the book with him. In part because I'd been recommending it to friends who refuse to read anything on the financial crisis. But mostly because it's such a complicated story that he handles with remarkable balance and discipline.
Andrew said his view on writing the book was akin to Tarantino directing a movie -- he wants everyone coming away believing they've read a different story. Interesting, clever, probably not my take (I generally want everyone to "get me." Though I suspect my general urge to be liked is greater than Andrew's.)
From my perspective, the thing Andrew got truly on the money, as it were, was his sense of humanity around all the major bankers (I think the public sector folks got a bit of a rougher ride). In 30 years, presuming a conversion, I suspect I'd like Andrew to be my rabbi. Perhaps unsurprisingly, the subjects disagreed. I didn't discuss the book with Merrill Lynch's ex CEO, John Thain, but I know him well ... and thought quite well of the portrayal. Not John's view, says Andrew. Same on Lehman's Dick Fuld -- and his annoyance with the book I've already heard from Dick's old friends.
Maybe the better take on Too Big to Fail is that if everybody finds something to criticize, he's hit it just right. Nah, that's clearly not right either. Just read it.
By Ian Bremmer and David Gordon
Now for the red
herrings, the places and problems where
we think there is less risk than meets the eye.
In Iraq, elections in March will spark violence as foreign militants try to undermine the transition to Iraqi national sovereignty. A U.S. troop withdrawal beginning right after the elections will invite more violence. We could see a Sunni election boycott. But compared to what we've seen before, and what might have happened, the overall story is remarkably positive. For the markets, Iraq is suddenly an opportunity. The institutions are becoming legitimate (even with the unresolved Kurdish issue), the army is starting to work, and most importantly, political leaders from all communities are beginning to recognize the value of Iraq's tremendous natural resource base from which all can benefit if they make the compromises to maintain stability in the country. For all their basic governance problems, there's very little chance of Iraq actually becoming a failed state at this point -- a meaningful risk even a year ago. It's not a place we're ready to vacation in, but we're bullish on Iraq.
Iraq is also moving in a positive geopolitical direction. Ties with Turkey have grown particularly quickly -- not just in the Kurdish region in the north, but in Baghdad. That's one of the few positive stories for Ankara this year. Arab states in the region are still hesitant to build ties with Iraq as they wait for clarity on its next government. Maliki hasn't been a popular figure with neighboring gulf Arabs, but they recognize that Iraq's economic consolidation won't wait for another four years, and they'll start making political overtures to Baghdad if Maliki's mandate is extended. And if the Iraqi prime minister isn't returned (which is certainly plausible), we'll see a stream of head of state visits to place relations with a new leader on a more solid footing. So whatever the electoral outcome in March, we're likely to see Iraq on a faster path to integration with regional political and economic infrastructure next year. Meanwhile, Iran's role in Iraq has quietly receded. Iran's controversial presidential election and subsequent state violence did nothing to improve Tehran's influence among Iraq's Shia population, where Iraqi nationalism has been steadily growing.
The headlines for Iraq next year will undoubtedly be the timing/delays/pace of the US troop withdrawal. But the real story is going to be a moderate government, growing geopolitical influence, and the most exciting new investment opportunities the region has seen in a decade.
AHMAD AL-RUBAYE/AFP/Getty Images
By Ian Bremmer and David Gordon
On balance, 2010 is looking like a tougher year for President
Obama than 2009 proved to be. Going into the new year, he has succeeded in
and climate change down the road, but pulling off real policy success on
either still looks unlikely. Unemployment remains high as the country pulls
weakly out of recession and mid-term elections appear on the horizon. While
Obama's popularity may take a beating, the coming year will see considerably
less actual domestic policy risk in the United States than in 2009. But the
exception is in the process of financial regulatory reform. That's likely to be
a tougher issue than people expect.
The reform package that passed the House of Representatives is comprehensive, though it will be moderated in the Senate, where for the first time under Obama a serious bipartisan effort is being undertaken. Either way, substantial change is afoot -- more far-reaching than anything we've seen since the Great Depression. The result will be a structure put in place to monitor and address systemic risk, largely self-financed from the financial community, as well as changes on many other issues, ranging from derivatives regulation to the proper role of the Federal Reserve Bank.
Unlike cap and trade or immigration reform, there's a very high likelihood that comprehensive financial regulatory reform will pass. But with mid-term elections approaching, it's likely to turn populist and lose a considerable amount of its bipartisan flavor. Congress as a whole is likely to imitate what's already come to pass in the United Kingdom, where an unpopular Gordon Brown government is going after the financial sector to try to lift its poll numbers from the morass. Congress doesn't want to be tarred by Treasury Secretary Tim Geithner, bailouts, or billionaire bankers. The best way to avoid that fate is to include some visibly populist elements in the new legislation, especially on consumer protection and executive compensation. Members of Congress will look to score points by taking aim at the Fed, but actual policy change there is a step too far -- the administration will likely ensure that nothing in the ultimate bill will undermine the Fed's political independence.
But while Obama's economic team will be wary of populist measures, Democrats in Congress and the president's own political advisors will see such measures as a necessary piece of "mobilizing the base" before mid-term elections. Big banks are an easy target, especially in the context of high profits and a strong recovery for the financial markets, but a weak overall economic rebound. The legislation should pass by late spring.
Regulators will be given significant new discretionary powers, including some authority for breaking up institutions deemed a systemic risk. A key risk is that, depending on the political environment, the newly empowered regulators could use their capabilities to issue strict rulings that go well beyond what is specifically included in the legislation. Regulators will also likely issue proposals for revising capital requirements upward next year.
Another key risk to watch will be efforts to impose further fees
and taxes on the financial system. With the U.S. government running record
deficits in the wake of the financial crisis, trying to recoup these costs from
the financial services industry will be seen as a relatively low-cost political
option. Executive compensation is one likely possibility; taxes on carried
interest for hedge funds are another.
Both the Americans and Europeans are aware of the risk of driving the financial industry into the ground with too much (or too drastic) regulation or taxation. But as reform becomes an election-year domestic battleground, the need to serve political interests will be increasingly at odds with the need to create an efficient framework for regulatory reform.
Next up: Japan.
Ian Bremmer is president of Eurasia Group, and David Gordon is the firm's head of research.
JEWEL SAMAD/AFP/Getty Images
By Sean West
Policymakers appear puzzled by massive Wall Street payouts. Why are the banks paying such large salaries and bonuses amid such political and public sensitivity to the issue?
There are a few possible explanations. They could be
enjoying one last hurrah before a new regulatory regime changes their ability
to earn blockbuster profits. Or they could be showing Congress and the
administration, both of which demonized the industry earlier this year, that
there's nothing either can do to stop them. Or perhaps it's much simpler: Pay
is how bankers measure success, so firms will go to any length to retain top
talent. Even if self-regulation could go a long way to currying political favor
in Washington, don't expect it from Wall Street. But massive payouts after a
year of taxpayer support at a time when unemployment is over 10 percent seems like a
recipe for populist backlash. So how likely is another bout of populism in
response to bankers' compensation? There will be plenty of opportunities to
find out in coming months.
In recent months, anger at bank pay has subsided as the administration has tried to bureaucratize the issue by appointing a "Pay Czar" and Congress has remained focused on healthcare. In March, Congress lurched into action over bonuses at AIG. Only a handful of votes away from passing draconian bonus clawback legislation, Congress earned its highest approval rating this session: 37 percent. But few members have said much on the subject since then. The White House and Treasury have followed a similar path: cognizant of a perception that the administration was becoming too interventionist, they bureaucratized the issue by appointing Kenneth Feinberg to review pay packages at banks receiving exceptional aid in order to protect taxpayer investments. Part of the calculation is to create an environment for the banks to remain competitive, which includes retaining talent that demands market-rate compensation. It was no surprise that his first set of rulings, which applied to the top 25 highest-paid employees at each of the seven largest TARP-recipient banks, got big headlines but had a relatively limited real impact.
Even if the issue is downplayed in the near term by a light-touch Pay Czar, it will be a long time before bankers are out of the woods. For starters, bankers' pay may again become a political lightening rod as Congress focuses on financial regulation reform package through early next year. This is particularly true if Obama begins to feel threatened by rising unemployment or if he senses that he is losing his base and needs to deflect anger. In that case, look out for fireworks as an election year Congress turns its attention to financial regulation in the first quarter of 2010.
It's not just up to the Treasury Department or Congress though. Banking regulators like the Federal Reserve are trying to get in front of the issue to prove their competence and preserve their current powers -- and whatever Congress passes, it will be up to the regulators to interpret and implement. Plus, a whole new round of legislating may follow from the Financial Crisis Inquiry Commission, which will unveil its report on what caused the market turmoil at the end of 2010. While Feinberg may be more of a technocrat than a czar, significant risk remains for a populist-driven response to bankers' pay going forward.
Sean West is a U.S. policy analyst at Eurasia Group.
STAN HONDA/AFP/Getty Images
By Ian Bremmer
The most obvious long-term effect of the financial crisis is a shift in economic decision-making power from capitals of finance to capitals of politics. We see this trend in the United States, where decisions on how best to value assets and allocate capital are now made in Washington on a scale unthinkable until about this time last year. Outside the United States, nowhere is this development more obvious than in the United Arab Emirates, where power and wealth have shifted at startling speed from Dubai (until recently a financial powerhouse) to Abu Dhabi (the seat of political power). But the American trend is temporary; the UAE's might not be.
Remember when newspapers, magazines, and TV business reports produced feature after feature on lavish investment in Dubai's newest architectural marvel and the corporatist management style of its ruler, Sheikh Mohammed al Maktoum? As foreign investment stopped flowing into Dubai, large-scale infrastructure projects ground to a halt. Thousands of foreigners lost work permits in the construction sector. Thousands more saddled with loans they could no longer repay simply abandoned their property and left the country. By January 2009, local police complained that about 3000 cars had been abandoned at the airport. Dubai found itself buried beneath a mountain of IOUs, and for a few days in February 2009, the financial world lost faith. The emirate's credit rating tanked, and foreign investors began to plan for the once unimaginable risk that Dubai would default on its sovereign debt.
Faced with that, Dubai announced a $20 billion bond program to raise the needed cash. In February 2009, Abu Dhabi moved in with $10 billion bailout, underwritten by the UAE's central bank. So far, Dubai has yet to find the other $10 billion, and Abu Dhabi may have to step in again. But the bursting of Dubai's real estate bubble and the sudden collapse of its economy have already allowed Abu Dhabi's ruling al Nahayan family to buy a big share of the al Maktoum's assets.
On a recent
visit, I saw the evidence for myself. Abu Dhabi is bustling as the city
state prepares for its first Formula One championship this Sunday. In Dubai, the traffic jams
are gone, the hotels are struggling, and everyone's waiting for something to
change. What a difference a year makes.
There's plenty of reason to fear that things won't get better soon. Real estate prices are now at about half their peak, but overbuilding on many projects continues because the state controls many of the emirate's largest construction companies. Many of Dubai's biggest construction projects are still underway, because the government wants to minimize further job losses. That's likely to continue through 2010, leaving the emirate with large amounts of unused commercial space.
In many cases, local firms haven't paid their employees in weeks,
and there have been some moderately violent protests. The government
appears aware of the seriousness of the problem and is working to improve
healthcare and living facilities for the laborers. Dangerous levels of unrest
are unlikely given that most guest workers can't afford to risk
But there's another cloud on the horizon. If the United States moves to intensify sanctions on Iran next year (a good bet given the low likelihood that the current diplomatic optimism will last), Dubai will be vulnerable. Much of Iran's financial flows move through Dubai, and sanctions would hit the emirate especially hard.
Ian Bremmer is president of Eurasia Group.
Ethan Miller/Getty Images
The Call, from Ian Bremmer, uses cutting-edge political science to predict the political future -- and how it will shape the global economy.