This year was never likely to get off to a particularly jolly start. With an election looming in the United States, a credit crunch haunting the global financial system, and growing political instability at every turn, the mood in January was gloomy to say the least. If there were any die hard optimists trying to lift the mood, the World Economic Forum soon snuffed out their hopes. The influential Geneva-based think tank released a remarkably downbeat report in January, forecasting the highest levels of political and economic uncertainty for a decade.
The outlook was so grim that the WEF in its Global Risks 2008 report called for “new thinking and concerted action” on a number of problems. The big threat, the report said, was that the current liquidity crunch would spark a US recession in the next 12 months. But there are three other major risks highlighted by the report: threats to the global food supply, the increasing cost of oil, and supply chains that are stretched to breaking point. These risks cannot be avoided, the WEF report said, but they can be better understood, managed and mitigated.
That financial risk should top the list of threats is no surprise. This time last year, some observers, including the WEFs own Global Risk Network, were predicting a re-pricing of risk in financial markets. They certainly got that one right, but nobody foresaw the scale and nature of the systemic financial crisis of 2007-2008. In the US alone, the Federal Reserve has projected direct losses related to the sub-prime crisis of US$15bn. The crisis “has raised fundamental questions as to the vulnerabilities within the current model of financial markets,” the WEF report said. In the good times, diversification of risk may have strengthened stability, “but systemic financial risk remains acute,” it added.
Changes in financial markets over the past two decades have led to the ownership of risks being decentralised, said the WEF, and generally this has been a good thing. For one, it creates greater opportunities for risks to transmit between individual firms and markets. But this also makes effective risk management all the more critical. Under normal market conditions, the financial system has improved its capacity to assume and distribute risk, and has become more stable, said the WEF. But, to mitigate the impact of the types of challenges seen in 2007, the report calls for increased public and private sector collaboration on stress testing, liquidity management, risk assessment and prevention to address what it describes as the “fragmentation of ownership of global risks.”
Divided economists
In the meantime, and looking at the year ahead, the WEF said a US recession is possible and noted that economists are divided on whether consumption-led growth in Asia is strong enough to drive the global economy. In Europe, the WEF warned that the prominence of the United Kingdom’s financial sector had made the country as a whole vulnerable. There were also large current account deficits in some central and eastern European economies that may prove increasingly unsustainable in 2008.
“Systemic financial risk is the most immediate and, from the point of view of economic cost, most severe risk facing the global economy,” said David Nadler, vice-chairman of insurance group Marsh & McLennan Companies, which helped to produce the report. “With so many potential consequences of the 2007 liquidity crunch unresolved, the outlook at the beginning of 2008 is more uncertain than it was a year ago.”
If the appearance of financial instability at the top of the big-risks list is a no-brainer, the mention close behind of “food security” might take more people by surprise. How many even know what the phrase means? In simple terms, this is the question of who gets to eat what, and how much we have to pay for our food. The WEF says this issue will move “from the periphery of the global risk landscape to its centre” and will become one of the major risks of the 21st century.
The world is moving into a period where food prices will be higher and more volatile. In 2007, prices for many staple foods reached record highs. Global food reserves are now at a 25-year low. That means world food supply is vulnerable to an international crisis or natural disaster. In some cases this has caused political instability, such as the “food riots” that hit some countries in 2007.
Looking ahead, the WEF said that the drivers of global food insecurity – population growth, lifestyle changes, use of crops to manufacture biofuels and climate change – were likely to sharpen over the coming decade, “positioning the world for a potential long-term trend reversal in food prices and leading to a set of complex challenges to global equity.”
Dealing with this insecurity will become an increasingly complex political and economic problem over the next few years, said the WEF. The consequences for some countries “may be harsh”, it warned.
Food is not the only area where the WEF is worried about the stability of future supply. The global supply chains on which international trade depends are vulnerable too, it said.
Increased efficiency
Improvements in technology and global logistics, along with reduced trade barriers, have led to a historic expansion of international and intra-regional trade over the past 20 years. On the whole, this has been a good thing. These improvements have generally led to increased efficiency and global prosperity. However, the WEF warned that “hyper-optimization” of supply chains – stretching the links in the chain to breaking point – might create new threats. The risk of a chain breaking becomes much higher, as does the damage that such a break could inflict. These threats “are often not fully understood,” warned the WEF, which added that while supply chains can share risk between many parties, “they can also cause risks to be aggregated.”
As every company and government that depends on external suppliers faces disruption to their supply chain, the WEF called for “an international approach to supply chain risk management across private and public sectors.” That would be one of the first steps to mitigating this risk.
The last of the four big risks highlighted by the WEF is the availability of energy resources. Energy is key to the global economy, but guaranteeing a safe, secure and sustainable supply – and doing so in line with global commitments to reduce greenhouse gas emissions – is increasingly problematic, it said.
With predictions of a 37 percent increase in oil demand over current levels by 2030, the WEF report sees limited scope for a fall in energy prices over the next decade. This may be good news for oil and gas producers, but it creates an inherent mismatch between those who bear risk and reward.
“The global economy has demonstrated remarkable resilience to increases in energy prices since 2004. But the limits of resilience may be close to being reached,” said Nadler from MMC. “Over the next two decades the supply of primary fossil fuel will become tighter with the world economy becoming much more vulnerable to price shocks as a result.”
The WEF report called for better dialogue on this issue at all levels – between emerging and developed countries and between the corporate sector and government and regulators. “A move towards a forward-looking regulatory framework is needed in order to ensure long-term economic viability,” said Nadler. “This framework should seek to unlock investment and innovation in cleaner energy and, ultimately, deliver an economic price for carbon.”
Highlighted risks
While the global financial markets could be blamed for causing at least one of the big risks highlighted by the WEF, the think tank said that financial markets will play a key role in mitigating all four of them.
Despite the financial turmoil of 2007, the financial markets are an increasingly important tool to transfer and mitigate an increasing variety of global risks, it said. The growth of financial markets has opened up new ways of doing this, including the rapid emergence of a new market in insurance-linked securities (ILS). These products help to provide additional capital to the insurance industry to protect against major catastrophe losses. While the early “cat bonds” were issued into the capital markets to help mitigate losses from wind damage and earthquakes, the ILS market has grown considerably in recent years in the range of risks covered, with total bonds outstanding now at more than US$34 billion.
Christian Mumenthaler, Member of the Executive Board of Swiss Re, who served for three years as the group’s chief risk officer, said: “The development of the ILS market has increased the ability of insurers and reinsurers to accept peak risks such as US hurricanes. This has become increasingly important because climate change has elevated the frequency and severity of tropical cyclones. The extra insurance capacity available through these instruments helps private companies and governments mitigate and manage these peak risks.”
Besides ILS, a wide variety of other financial instruments are now being developed to transfer insurance risks, including weather derivatives. “The weather derivatives market has grown at an explosive rate in recent years,” said Mumenthaler. “For example, these instruments can provide rapid payments to governments and farmers who can use them to hedge against too little rainfall and excessive heat in the growing season, along with too much rain in the harvesting season. In this way, both the state and commercial growers can invest in crop production with a greater degree of confidence, helping to optimise food production and security.”
Another way of mitigating these big risks is improved coordination between governments, said the WEF. When it published its 2007 risk report last year, it recommended the institution of country risk officers and flexible issue-based international coalitions to manage the complexity of the global risk environment.
Institutional arrangements
Its 2008 report looks at the specific example of the UK’s Civil Contingencies Secretariat and establishes a set of principles for country risk management which may apply across different institutional arrangements. An international forum of country risk officers could potentially offer a much improved capacity to exchange information about inherent cross-border global risks, and also improve the global ability to anticipate and respond to risk, it said.
“In order to maintain the benefits of globalisation, improved governance of globalisation is vital,” said Charles Emmerson, associate director of the WEF and editor of the report. “In all the focus areas of this year’s report, principles of equity, management of trade-offs and long-term global cooperation will be necessary. The short-term outlook is highly uncertain in 2008, but we must not lose sight of longer term challenges.”
Professor Klaus Schwab, founder and executive chairman of the WEF, said the current global risk outlook “points to a future of tremendous challenges, but also opportunities for business and government decision-makers to demonstrate their leadership.” The fact that so many of the global risks discussed in its latest report are connected with each “reflects the need for a collaborative framework for response.” Whether governments can provide that level of leadership and a willingness to work together remains to be seen.
