About four–five years ago, if you wanted to talk about risks, they weren’t easily manageable but on some level you knew what they were. You knew you were going through a slowdown. You knew that oil prices were uncertain. You knew what the nature of the risk was.
The kinds of risks that we are facing today are so complicated and unusual, that we don’t even know the nature of the risks. What does Brexit actually imply? What would Donald Trump’s presidency actually mean for the world markets, world stability and globalization in general? These are not easy questions to come to grip with.
The four instabilities
1. Europe dealing with Brexit
2. The US struggling to sustain growth
3. China facing a prolonged slowdown
4. Emerging markets confronting low global demand
Europe & Brexit
Europe is not dealing with just Brexit, but with profound crisis of integration, which works in two different directions. First, are the individual nation states of the European Union content with each other? Have they continued to buy the idea that European Union will grow ever closer? will it become a more efficient way of sharing resources, of pooling knowhow, of transferring people, and of harmonizing regulations? This has been one of the founding assumptions of Europe for a very long time, for at least 40 years. Is that idea reversing? There are good reasons to suppose that it will.
The other integration Europe is dealing with is of its people. Not just the generation of migrants that have been living in Europe for 15–20 years, but also the flood of new immigrants that have come into Europe from the giant dislocations in West Asia and North Africa. There are Syrians, Libyans, people from even further off, Kurds, all coming to Europe. Europe has no way of keeping them out, and if you keep them out, you are essentially creating the kind of humanitarian crisis on your border that nobody in Europe is capable of dealing with it.
Whatever happens with European societies is something we need to deal with. Why does this matter for the economy? What does it mean for a society to have a complete breakdown of trust? One of the classic differences between an advanced economy and an economy like ours is that their transaction costs are low. They don’t have to invest in systems that ensure interpersonal risks are taken care of. High trust societies essentially are efficient societies, where you do not have to ensure the daily work of managing trust between individuals. In our society, you can come up with examples of ways in which if you don’t trust people within your organization, your customers, or your bosses. It reduces cohesion and increases cost within a company and for the economy in general.
What you have to deal with is the possibility that Europe is transitioning from being a high trust society to a low trust society. A reduction in integration in Europe might increase transaction costs because of the trust deficit created, and that’s a fundamental change to the European economy that not a lot of people are prepared for. That kind of risk is not something which is easy to price, but matters to anyone who does business in Europe.
In the middle of this integration of its minorities, comes the strange and unexpected event which is Brexit. What does Brexit mean for Britain? The Bank of England is taking interest rates to its lowest level in centuries in Britain. It is saying is that we are uncertain now about Britain, and we have to make capital cheaper than it has ever been. Through history, Britain has been the safest country in the world to invest. It is institutionally the strongest, and the most predictable. They have just thrown that assumption out of the window. This matters for us more than it does for most other countries around the world because we have had British bias in our investments for a long time. We invest more in Britain than in the rest of the Europe put together.
Britain still has a special economic relationship with this country, even 70 years after independence. So we have to try and work out now what it means for Britain to no longer be an island of stability in a disordered world. It is now a source of disorder rather than source of order. That is the first big problem picture with Brexit, but the influence that Brexit has on Europe is also unpredictable. Will it increase the tendency for Brexit type parties to take off in various parts of Europe? Or, will it, in fact, paradoxically cause the European community to be stronger now that Britain which was always an outlier in terms of its commitment to the European project has left the table? We don’t know even where Europe is going after Brexit. We don’t know if Europe is split apart or whether Europe will get stronger. If you don’t know even that much about the European project, how will you predict what the European Central Bank will do? How can you predict whether the European individual banking systems will come closer or further apart? How can you predict how European regulations will be like 10 years down the line? Will it be still set by a single agency, or will there be multiple agencies? This is a future with multiple possibilities, and they are further apart than just two years ago.
The US is struggling to sustain growth
I say it is struggling to sustain growth, and it has shown politically. When Donald Trump stands up and says I am redrawing the electoral map of America, what he is trying to say is that I, as a Republican, am going to win in places where no Republican has won for 40 years. What he is trying to say is that there have been so many people who have been left behind by American growth in the past, that they will turn to somebody like me, in spite of the fact I am not the natural leader for their communities. So these are communities that have organized labour, they are cold mine communities, and they are steel working communities. These are people and communities that have voted Democrats for generations, for election after election. Donald Trump now says and many people believe he is competitive in areas where no Republican has ever been before.
We don’t know if people who have never previously voted will come out to vote for Donald Trump. The polls are not safe because they poll likely voters, they don’t poll unlikely voters, and Donald Trump’s appeal is to unlikely voters. These polls are not something which you can rely upon. Remember polls were not reliable for Brexit…
There is an additional source of risk and disorder here. What could Donald Trump presidency mean? We actually have to go to Cold War mentality because this is someone who, according to reports, has apparently asked three times in his intelligence briefings exactly how he can use the nuclear button. This is not a question that most people running for President first ask. He also asked why it is that US should not use nuclear weapons first. So Donald Trump breaks the mould. This is extraordinary source of risk. We have had crazy people becoming leaders of powerful nations before, but never of the USA. Even George W Bush, who many thought was unpredictable and dangerous, in retrospect, looks like a model of calmness, sanity and restraint.
Slowdown in china
China is facing a prolonged slowdown and there are political risks behind this as well. We all know the numbers, 6.25 per cent, 6.2 per cent, may be lower than that, but what lies behind those numbers is the inability of the Chinese central government to deliver the kind of growth that is the basis of the Communist Party’s hold on its people. The Communist Party’s power exists because of the contract with the Chinese people that they will provide stability and growth and you do not question our rule.
What lies behind the 6.2 per cent or 6.4 per cent growth is what we in India should be familiar with. They are finding it difficult to pump good money after bad. They no longer want to pump money into giant real estate schemes, or into big infra building schemes in many parts of the country, which is fine, even great from the economic perspective, but just like in India, there are entrenched interests in China that benefit from those schemes, there are powerful people who like the idea of lots of money going into infra and real estate. These are pools of cash that are easy to skim money off the top. And when somebody comes in and takes the flow of cash away, you begin to dislike that person…
In a system like this, which is not transparent at all, you never really know the pressures that are put on it until it breaks. With a system like ours or that which exists in Europe or America, you can see the pressures. But here we don’t know the degree to which the Chinese President is putting pressures on the internal systems. There is an unknowable political risk in China right now. At any point of time, something might break. We don’t know if it is the People Liberation Army that will one day decide that too many of its contracts have been taken away or if there is a revolt by politburo. We have no way of predicting the risks or quantifying it. Again, this is not something that existed five years ago, when under the previous administration in China, we knew how stable it was. It was far more transparent then.
Emerging markets confronting low global demand
Finally, we have emerging markets, which are confronting low global demand. It means that these markets which depend crucially on exports, frequently of commodities, just don’t have the cash that they had five to ten years ago. What is the result of that, you have chaos…in South Africa, where a ruling party, African National Congress, is breaking apart. It is about to face an insurrection, to split apart and is very close to its Junta moment. All these large emerging markets, which once had enormous amount of money with which they were constructing welfare state, now no longer have the money, and therefore, their political consensus is falling apart. We don’t know which will be the first to go. Turkey has already gone. Any of these markets could be next.
Globalization no longer An unstoppable force
These are the four instabilities that we are dealing with. Now, what is the larger question you should ask, when you look at these four pressure points in the global economy?
The first and the biggest is that globalization is not the unstoppable force that we once always assumed it to be. At least since 1989, when the Berlin Wall fell and definitely since the WTO came into force, there has been a sense that there is this train barreling forward to the future. You had Raghuram Rajan, former RBI governor talking about a borderless world, but is it really going to be borderless in future? You also saw Donald Trump threatening to put up a wall, and saying the rest of the world is already at war with America. You also saw Britain choosing to set up barriers between Europe.
Many countries that were the engines of global integration are now turning their back on it. It does not matter if Donald Trump does not become president from the point of view of globalization, because he has already won an argument. Hillary Clinton has already come out against the trans-pacific partnership, the big trade deal that she supported untill last year. Whoever comes after Donald Trump for Republican party, will also be anti-trade, anti-globalization and anti-immigration. Whoever takes over in Britain, is going to be anti-immigration, it is going to be cut off from Europe. It does not matter whether people who ran Brexit, run Britain or not. Politicians are responding to actual feeling in societies, that globalization has gone too far.
In the week when Brexit happened, I was speaking at a festival of finance organized by Financial Times in London. There were all these finance heads who had spent 20–25 years praising globalization, defending it, and explaining it to their companies, markets and the world. In the week after Brexit, they were talking about how globalization was a bad thing. When heads who move money around start saying that globalization is bad, obviously globalization has gone too far, and you have to start thinking.
From our point of view, they benefitted from globalization, next China benefitted from it, and now when we have come to the front of the line, they are shutting the door on our faces. We don’t know whether trade integration is going to go in the direction that we expected it would. We don’t know whether financial integration would continue to increase. These are not assumptions that we can hold any longer. This, again is an unknowable risk.
What this essentially means is that there is excess capacity all over the world, and our own recovery, long investment slump, shows no sign of offending, because we continue to deal with excess capacity in sector after sector. Who is going to invest, when there is so much excess capacity in these sectors – in steel, in auto, in so many other locations. How are we going to deal with this excess capacity? How are we going to deal with this demand slowdown? We have no answer as yet. There is a fundamental change in how we think about business cycles including in our country that we need to deal with, and we haven’t started thinking about yet.
"Globalization is no longer the unstoppable force that we once assumed. ...Many countries that were the engines of global integration are now turning their back on it."
There are also two positive ways to think about it. Domestic stability means we can see risks elsewhere. It tempts us to see risks elsewhere. We say we have good macro numbers and a stable exchange rate. Most of our companies are seeing good revenue growth. This is the time for us to take a risk or two. But should we be really doing that? In a world which is so risky should we be looking at our own macro numbers, our own company numbers in isolation from these events? We think we have a decent exchange rate or stable exchange rate but do we know where oil is? Do we know where West Africa and North Africa is? Do we know what is going to be happening with financial flows over the next year? We look at our macro numbers and there is always that temptation, so that is something that we should be thinking twice about.
The second thing that we know always happens when opportunity that we see is whenever there is large amount of cash not earning money, it tries to break out. Now West is full of piles of cash and we are the only country that is growing. We have not been able to create that pipeline yet…At some point these funds will start flowing into India. How do we deal with the sudden flood of cash again?
Go with caution and diversify
When you have so much unknowable risks, you can not put your eggs in one basket. India looks stable but is it really? You might want to go into geographies that look good but are they really going to be looking good two years down the line. All you can do right now when you have absolutely no idea what the future is going to look like is operate with two watchwords, caution and wanting to diversify. That’s all I believe you can do.
When I say diversify, what I am trying to say is it is very easy to look at growth in America, and apparent stability, historical stability of Britain, to look up at the opening up of European markets, opportunities in China and in South East Asia and say we need to look into different geographies. It is also very easy to say look things are about to develop in India and we should just keep cash with us in such a way when investment opportunities open up here, we are ready to take them. Never go with one of those options is all I am saying, because anyone of those options is unpredictable.
—Mihir Swarup Sharma is Senior Fellow, Observer Research Foundation. This is the edited transcript of his session at the 7th CFO Leadership Conclave, held in Visakhapatnam during August 5-7.