A Flock of Black Swans

Jeffrey Frankel

20 August 2012
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CAMBRIDGEThroughout history, major political and economic shocks have often occurred in August, when leaders have gone on vacation believing that world affairs are quiet. Consider World War I’s outbreak in 1914, the Nazi-Soviet pact in 1939, the Sputnik launch in 1957, the Berlin Wall in 1961, and the failed coup in Moscow of 1991. Then there was the Nixon shock of 1971 (when the American president took the dollar off the gold standard and imposed wage, price, and trade controls), the 1982 international debt crisis in Mexico, the 1992 crisis in the European Exchange Rate Mechanism, and the 2007 subprime mortgage crisis in the United States.



Many of these shocks constituted events that had previously been considered unthinkable. They were not even on the radar screen. Such developments have been called black swansevents of inconceivably tiny probability.



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But, in my view, “black swan” should refer to something else: an event that is considered virtually impossible by those whose frame of reference is limited in time and geographical area, but not by those who consider other countries and other decades or centuries.




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The origin of the black swan metaphor was the belief that all swans are white, a conclusion that a nineteenth-century Englishman might have reached based on a lifetime of personal observation and David Hume’s principle of induction. But ornithologists already knew that black swans existed in Australia, having discovered them in 1697. They should not have been viewed as “unthinkable.”



.Before September 11, 2001, some experts warned that foreign terrorists might try to blow up American office buildings. Those in power did not take these warnings seriously. After all, “it had never happened before.” Many Americans did not know the history of terrorist events in other countries and other decades.




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Likewise, until 2006, most Americans based their economic behavior on the assumption that nominal housing prices, even if they slowed, would not fall, because they had not done so before – within living memory in the US. They may not have been aware that housing prices had often fallen in other countries, and in the US before the 1940’s. Needless to say, many indebted homeowners and leveraged bank executives would have made very different decisions had they thought that there was a non-negligible chance of an outright decline in prices.



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From 2004 to 2006, financial markets perceived market risk as very low. This was most apparent in the implicit volatilities in options prices such as the VIX. But it was also manifest in junk-bond spreads, sovereign spreads, and many other financial prices. One reason for this historic mispricing of risk is that traders’ models went back only a few years, or at most a few decades (the period of the lateGreat Moderation”). Traders should have gone back much further – or better yet, formed judgments based on a more comprehensive assessment of what risks might confront the world economy.



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Starting in August 2007, supposedly singular black swans begin to multiply quickly. Big banks don’t fail?” No comment. “Governments of advanced countries don’t default?” Enough said.




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Debt troubles in Greece, especially, should not have surprised anyone, least of all northern Europeans. But, even when the Greek crisis erupted, leaders in Brussels and Frankfurt failed to recognize it as a close cousin of the Argentine crisis of 2001-2002, the Mexican crisis of 1994, and many others in history, including among European countries.



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Nowadays, a eurozone breakup has become one of the most widely discussed possible shocks. Considered unthinkable just a short time ago, the probability that one or more euro members will drop out is now well above 50%. A hard landing in China and other emerging markets is another possibility.



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An oil crisis in the Mideast is the classic black-swan event. Each one catches us by surprise: 1956, 1973, 1979, 1990. Oil prices can rise for many other reasons, as they have in recent years. But the most likely crisis scenarios currently stem from either military conflict with Iran or instability in some Arab country. The threat of a supply shock typically fuels a sharp increase in demand for oil inventories – and thus in prices.



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The most worrisome financial threat is that currently over-priced bond markets will crash. In theory, inflation (particularly commodity-induced inflation, as in 1973 or 1979) could precipitate a collapse. But this seems unlikely. Default in some euro countries or political dysfunction in the US is a much more likely trigger.


.Evidence of extreme dysfunction in US politics is already plain to see, reaching a low in 2011 during the debt-ceiling showdown (also in August), which cost America its AAA sovereign rating from Standard & Poor’s. In theory, as the “fiscal cliffset for January 1, 2013, approaches, fearful investors should start dumping bonds now. But investors still believe that politicians, aware of the dire consequences of going over the cliff, will again find a last-minute way to avoid it.



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Perhaps observers believe that a clear result in November’s elections, one way or the other, would help to settle things. A true black swanlow probability, but high enough to think about – would be a repeat of the disputed 2000 presidential election. There has been no reform since then to ensure that people’s votes will be counted or that a disputed outcome will not be resolved by political appointees.



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Scariest on the black-swan list is a terrorist attack with weapons of mass destruction. There is a long-standing gap between terrorism experts’ perception of the probability of a nuclear event and the probability as perceived by the public. (Admittedly, the risk is lower now that Osama bin Laden is dead.)



Last on the list is an unprecedented climate disaster. Environmentalists sometimes underestimate the benefits of technological and economic progress when they reason that a finite supply of resources must imply their eventual exhaustion. But it is equally mistaken to believe that a true climate disaster cannot happen simply because one has not already occurred.



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Have a nice vacation.




Jeffrey Frankel, a professor at Harvard University's Kennedy School of Government, previously served as a member of President Bill Clinton’s Council of Economic Advisers. He directs the Program in International Finance and Macroeconomics at the US National Bureau of Economic Research, where he is a member of the Business Cycle Dating Committee, the official US arbiter of recession and recovery.



Europe should choose whether it wants Greece in or out

Jean Pisani-Ferry

August 22, 2012

 



For the third time in three years the Europeans’ stance on Greece is economically inconsistent.



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The first time was in 2009-2010 after then prime minister George Papandreou indicated that he would need to file for assistance from the International Monetary Fund. The European response was to reject the principle of IMF intervention while not offering an alternative to it. It took several months until an agreement was found, in May 2010, to combine European and IMF conditional support.




The second time was in 2010-2011 when Greece’s solvency became the urgent issue at hand. Two camps emerged. One advocated swift debt restructuring, emphasising that Greece was a unique case and that markets could be convinced that no other European country would follow suit. The other one stressed the adverse spill-over effects of a default and favoured keeping Athens afloat through cheap loans. The compromise was to lend at penalty rates while letting markets expect that restructuring would perhaps come, but at a later date. Each of the two positions was internally consistent but the compromise was not. It took more than a year, until the second half of 2011, to recognise this contradiction.



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The third time is now. Again, Europe is divided. One camp, well represented in northern Europe, considers that Greece should leave the eurozone because it is not fit for purpose either economically or politically. This view is actually held by both eurosceptics (who want to demonstrate that exit is possible) and europhiles (who hope to win over opposition to further integration). The latter camp, more vocal in France and southern Europe, is adamant that the integrity of the eurozone must be preserved, because Greece’s departure would have adverse contagion effects on other southern countries.




Each of these positions is also internally consistent. But it is not consistent to urge an exhausted country to make all possible efforts to meet the targets of the IMF/euro area programme, while fuelling anticipations of a forced exit.



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For domestic agents, the risk of the financial disruptions an expulsion would cause acts as an incentive to export capital or hoard cash. For foreign investors, including overseas Greeks, it is an incentive to refrain from investing in the country in the hope of future bargain acquisitions. In such conditions one should not wonder why investment in the first quarter of 2012 was only 46 per cent of its level four years previously (in fact one may wonder why it was still so high). But without investment and a return of confidence, Greece is bound to remain caught in a vicious circle of recession and whatever its efforts, it is unlikely to meet its creditors’ demands.





European leaders should choose. If they really think they would be better off with Greece out they should offer it an exit package.



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Evidently, an exit will cost them dearly because the sharp currency depreciation that is certain to take place will force the country to default on its euro liabilities. Also, Athens will remain in need for financial support, if only because it is still far from having returned to budgetary and external balance. 



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The credibility of the euro will suffer and other countries will have to be protected from contagion. And finally the EU cannot forget Greece because whatever its fate in the EU, it will remain in Europe and will matter for the whole continent. So on closer examination the option looks less attractive and more dangerous than seems at first sight. But at least it has an internal logic.




If the Europeans accept that a Greek exit is not in their interest, they should recognise the efforts made and give it a real chance to adjust further and recover within the euro. Obviously they cannot remove the redenomination risk entirely but they can at least make speculation of exit a less-assured bet.
 
 
 
Beyond a reasonable extension of the assistance programme, this means giving clear signals that Europe believes in a possible success. One possibility, which is certainly not without difficulty, would be a conditional relief on the debt to official creditors, what the jargon calls official sector involvement. Another one would be to foster public and private equity investment, through debt-equity swaps, investment by international financial institutions (such as what the European Bank for Reconstruction and Development has done in eastern Europe), or a revival of the too quickly derided Eureca plan for the pre-privatisation once proposed by Roland Berger, the consulting firm. The key is that private agents can only believe in the revival of Greece if the Europeans themselves invest in it.
 
 
 
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When Prime Minister Samaras meets with fellow European leaders later this week, he should offer them a small gift for late summer reading: a copy of Alfred de Musset’s play, A door must be either open or shut. It is short and inspiring.




August 20, 2012 7:54 pm

Finance: The path to power
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A herd of cattle is led down a large road connecting Ha Giang, Vietnam©Corbis
A road to build: a dirt track in northern Vietnam leading to China illustrates the region’s need for infrastructure




In April 2010 the US power company AES signed an agreement to build a 1,200 megawatt power plant in the Vietnamese province of Quang Ninh. The $2bn project was three times larger than any previous power deal in the country.




At first glance, it would seem an alluring scheme. Vietnam is a dynamic emerging market of 88m people and is expected to double its electricity output between 2010 and 2015. But John Haberl, an executive at Virginia-based AES, admits it was a battle to entice the banks. 
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“We really wondered if we could raise the financing,” he says. “A few months later, as the problems in Europe became more evident, it couldn’t have gotten done.”




Ultimately the funding came from sources not usually associated with big US-led projects. Much of the debt financing came from Export-Import Bank of Korea (Kexim) and the equity from a group that included the power unit of South Korean steelmaker Posco and the Chinese sovereign wealth fund China Investment Corp, which has a 15 per cent stake in AES.


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Increasingly, such institutions are set to take centre stage as companies seek a slice of a raft of infrastructure projects across south Asia.




There is little doubting the region’s allure. The Asian Development Bank estimates that investment in infrastructure will total at least $8tn over the next decade. Of more than $400bn-worth of global infrastructure projects last year, 47 per cent were in Asia.




Crucially, businessmen and bankers say most of the funding will not come from traditional commercial banks. The global financial crisis, compounded by fragility in the eurozone, means a new template is emerging. A leading role will be played by a group of state-run export credit agencies from east Asia whose fortunes have been boosted by the problems of private sector banks, particularly in Europe. Among the Americans, JPMorgan is active in Australian mining projects but otherwise, like Citigroup and Bank of America, largely absent from big Asia-Pacific projects.




Instead of the big western names, the driving forces of infrastructure funding look set to be Seoul’s Kexim, Japan Bank for International Cooperation and the two big policy banks of China: China Development Bank and China Export-Import Bank.

 


Such institutions use their deep pocketsbolstered by teeming foreign reserves – to support contractors from their own nations. The phenomenon is not new. Japan and South Korea became dominant in Gulf infrastructure building, partly because of the strength of their state credit agencies. But until now these institutions have had low profiles. The scale of the infrastructure drive planned across south and south-east Asia – from Cambodian airports to Vietnamese nuclear power stationsstands to give these state lenders a far more prominent position in global finance.



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While the lion’s share of capital will have to come from such institutions, there are still opportunities for the European banks in the region to add value through their knowhow. For example, HSBC co-ordinated the financing for AES’s Vietnamese project and is increasing such business. “Infrastructure finance is a market where HSBC is able to demonstrate its core strengths of advising global clients . . . at a time when other banks are pulling back,” Stuart Gulliver, the chief executive of HSBC, told the Financial Times.



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Standard Chartered is playing a similar role in co-ordinating South Korea’s landmark $20bn deal to build nuclear reactors in Abu Dhabi, although most of the capital is expected to come from Kexim.




Still, some feel western banks may only have five or so more years to enjoy such a privileged position as project leaders.



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“The export credit agencies will globalise and need the international banks less. And in a few years many of the deals will be renminbi deals,” says one project-finance banker in Hong Kong.




AES has access to its Korean financing in Vietnam because Doosan Heavy Industries is working as a contractor on the project.


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AES drew on a previous good rapport with Koreans. Not only were Chinese and South Korean bids more competitive than the Japanese but AES had also worked with both Posco and Kexim on a project in Chile and found them to be reliable.



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Moreover, thanks to the CIC connection, if the Korean funds proved inadequate, “we could always bring in the Chinese at a later date, if necessary”, says Chad Canfield of AES, who worked on the deal.




Their state credit agencies’ cheap, long-term capital is a powerful competitive advantage in winning contracts that run into the billions of dollars. But they bring another dimension too. Today, politics and the financing of infrastructure have become intimately intertwined.



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The competition for these multibillion dollar projects is becoming more fierce. Japan has run out of room to lay more roads and has already lined its rivers with concrete. China is completing its transport and high-speed rail networks. South Korea is seeking to expand its nuclear exports to emerging markets such as south Asia and Turkey.



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But gaining the right to build core infrastructure is hugely political. The shifting partnerships on projects lay bare the diplomatic alliances and faultlines in the region.




As China’s relations with its neighbours have become more fraught over matters such as tensions over energy reserves and fishing rights in the South China Sea, politics have become a bigger factor in commercial decisions. There is now a backlash against China in much of the region that the Japanese in particular are seeking to exploit.



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“The trust deficit is a real issue when it comes to China,” says the head of one major Asian bank based in Singapore. Asians are wary of China, though that is where the money is.”




That is especially the case with Vietnam and the Philippines, whose sparring with China over the South China Sea has become more intense.


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It is easy to be tarnished. When one Japanese trading house teamed up with China Resources to bid for a power project in Vietnam, Vietnamese officials privately told them such an alliance was not a good idea, one trading company executive says. “We thought China has great power over Vietnam but actually, the Vietnamese don’t like the Chinese,” this person notes.



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There is also resentment of the Chinese in Indonesia, over a pattern of trade whereby China imports raw materials and then sells Indonesia the processed goods made from them. That discontent was openly expressed last year during the visit of Premier Wen Jiabao to Jakarta.



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Japanese companies seek to take advantage of the fact that they have no territorial disputes in south Asia. Japanese trading companies have a long history of operating in the region and, thanks to the financial support of JBIC, they can offer attractive long-term financing to match the Chinese.



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Meanwhile, in many cases the Koreans can benefit from the fact that both of their giant neighbours are regarded with some suspicion. In some places in Asia, Japan is still treated with suspicion for its imperial expansionism in the last century.


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China is often seen as suspect because of its perceived ambitions today. Vikram Chakravarty, an analyst at Kearney, says the “the Koreans have been the most visible and perhaps the most successful” in finding a compromise between the quality of the Japanese and the speed and low cost of the Chinese.



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Today the Koreans are often best placed for winning infrastructure mandates. Prices for Korean equipment are attractive, thanks partly to the appreciation of the Japanese yen against the won. The Koreans are also good at managing projects (a skill that rivals at Japanese trading companies attribute to universal military service in South Korea).


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Meanwhile, under its chief executive Hiroshi Watanabe, a former senior finance ministry official, JBIC has enjoyed a renaissance. To compensate for their high cost base and because of intense internal competition, executives at Japanese trading firms who put deals together say they are all reducing margins to win mandates. They have also sought to put pressure on their government to support their efforts in countries such as Indonesia, where competition is particularly intense.



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Perhaps the most formidable competitors today for all but the high-tech projects are the Chinese. China has natural economies of scale given the size of its own domestic infrastructure investment. With so much now in place, to keep its assembly lines operating Beijing has to seek international business. And its bids often reflect factors that are not purely commercial. For example, China now has a strong export order book for its train carriages, but “it is the ministry of railways that decides the price depending partly on demand in China itself”, says one senior planner at a Japanese trading company.




Such considerations serve partially to offset rising wage, material and transport costs, which are up as much as 60 per cent over recent years. Recently, even the Chinese financing for dollar-based projects has become more costly.




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In both India and Indonesia there are complaints about the quality of Chinese equipment in power plants, according to analyst Aashish Agarwal at CLSA in Hong Kong. Moreover, questions remain on the software and services side.



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On Philippine and Indonesian power projects, for example, rivals say the use of Chinese equipment and contractors caused drawbacks and delays. China is often too hasty,” says another trading company executive in Tokyo. “Often they have sequence problems. You need to check everything. To control Chinese people is a mess.”




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However, rivals also concede that as the Chinese overcome quality concerns, they will “progress step by step”, this person adds.



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But one of the highest-profile infrastructure deals in Asia – a 2,000MW power project in central Javashows why the Japanese still have some edge. A Japanese group consisting of J-Power, Itochu and Indonesian coal miner Adaro Energy with money from JBIC saw off heated competition from the Chinese. The $4bn project is the largest independent power project in Indonesia and uses so-called supercritical technology, which favours the Japanese. Bankers say the Japanese stepped up their official development assistance to the country before the award as part of a renewed courtship of south-east Asia.


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As long as private sector banks are constrained, the business of infrastructure is likely to remain hugely political. Today, the deep pockets of north Asia are the most visible. When the Europeans and the Americans recover their appetite, they may find they are no longer quite as essential as they once thought.




A relative minnow with a broad mandate




Last November, a little-known Chinese fund joined Baring Private Equity and Deutsche Bank in taking a stake in Asia Potash, a company that had obtained concessions from the Laotian government to develop mines in the country.




The China-Asean Investment Co-operation Fund trumpeted its investment as “of strategic importance to the region”, adding that the scheme would probably become the largest potash producer in Asia.



The project, intended as a source of cheap fertiliser, is important to Beijing – which is why China Development Bank is extending loans of $5bn to complement equity from CAF.



CAF’s mandate is to contribute to the prosperity of China while helping its neighbours to develop. It was established in 2010 to a more modest fanfare than the one that accompanied the birth of its big brother, China Investment Corporation, three years earlier.



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Today, with $1bn under management, it is a relative minnow among China’s sovereign investment arms – but ultimately it plans to raise $10bn to buy stakes in companies and projects throughout south-east Asia. That is serious money for any private equity fund dedicated to investing in the region.




Shareholders include the International Finance Corporation, the investment arm of the World Bank that provides the fund with further clout as it scours Asia for opportunities in transport, energy and natural resources. CAF’s biggest shareholder is Export-Import Bank of China, which makes loans to schemes across the region.



CAF itself seeks equity investments in both new and existing projects, a broad mandate that gives the fund considerable leverage. Even experienced counterparts such as the Canadian Pension Plan or Government of Singapore Investment Corporation prefer to steer clear of greenfield projects and put their money into schemes that already generate cash flow.



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In addition to the Laotian project, the fund has invested in Thailand’s largest port and a fibre-optic network in Cambodia. It also helped Negros Navigation, a Philippine shipping company, buy Aboitiz Transport Systems, the country’s largest shipping and logistics group.


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At a time when funding from other sources is increasingly scarce, the fund’s leverage can only grow.




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Copyright The Financial Times Limited 2012