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Tail-risks throw shadows over global economy

Trumponomics, China and European politics fuel uncertainty in year ahead

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After an extraordinary year in 2016, many await with a mixture of curiosity and perhaps some trepidation to see what this new year will bring. As a practitioner of the dark arts of economics, I can pare my list of uncertainties to four key areas: economic policy under a Trump presidency and outlook for the U.S. economy; the related question of prospects for U.S. interest rates and the dollar; developments in the Chinese economy, capital outflows and the renminbi before the crucial 19th Communist Party congress in late 2017; and the extent to which politics in Europe pull the EU toward disintegration. Before examining these issues there is also a bigger picture to explore, about the context in which they will evolve.

It will not have escaped notice that 2017 marks the centenary of the Russian Revolution, but this is of more than academic interest. It is also the centenary of the entry of both the U.S. and China into World War I. For Russia, the U.S. and China, the war proved to be politically decisive for the very different paths they chose during the 20th century. In some ways, we could argue today that they have come full circle.

The "American Century," defined by U.S. economic, technological and military dominance, may be a going concern, but there is no question that it is over -- at least for now -- expressed as a system of U.S. political leadership. The rules-based system, which the U.S. built and championed, especially in the last 70 years, is withering, partly as the U.S. itself withdraws from it, but also as China and Russia are now willing and able to press their own geopolitical and economic claims. Instead of being determined by rules and trusted international institutions, the world's political and economic system seems to be more subject to the expression of self-interest by the incoming U.S. President Donald Trump, China's Xi Jinping and Russia's Vladimir Putin.

We will scrutinize the implications as they pertain to security in Europe and the South China Sea, climate change negotiations, and an array of geopolitical and economic issues. But a key issue for the world is the governance of the system ordering trade and investment. If we lose the U.S. as the principal defender of a liberal trade order, the risks -- from "Balkanized" trade arrangements to outright trade wars -- could be considerable. This is especially important for Asia, not just because of China, but also because of the complex and intricate supply chains that have evolved with China at the hub.

Trade friction

The background is not auspicious. In December, the U.S. and EU upset China by refusing to agree to support "market economy status" for China, which Beijing claims was promised for the 15th anniversary of its entry to the World Trade Organization. The dispute, based around the rules governing anti-dumping duties, has been referred to the WTO, but there are more immediate sources of concern about the risk of trade friction.

Trump has already stated he would withdraw the U.S. from the Trans-Pacific Partnership trade agreement on his first day in office. He has accused China, and other countries, of cheating at trade, and threatened to label China a currency manipulator, and levy tariffs on Chinese goods. He has nominated Peter Navarro, a known China hawk, to head up a new National Trade Council with a mission to protect U.S. manufacturing and jobs, and oversee policies designed to cut America's trade deficit. Since China accounts for about 70% of the U.S. trade deficit, it is clear where his focus will lie.

There is little question that China would retaliate in the event of aggressive U.S. trade policies. Accentuated trade tension between the two countries would most likely affect China more than the U.S., and would surely reverberate throughout Asia, with first-round effects especially in Taiwan, Singapore, Thailand and Japan.

While trade looms over the global economic outlook, we will certainly be busy with more familiar themes, and assessing how they might evolve.

U.S. financial markets have been exuberant since the Nov. 8 presidential election, buoyed by the prospect of tax cuts, especially for companies and higher-income groups, and the prospect of increased infrastructure spending. So-called Trumponomics is basically about swinging toward the use of fiscal policy for the first time since the 2008 global financial crisis, and at a time when the U.S. economy is not only emerging from a five-quarter slump in profits and economic growth, but also at more or less full employment.

Bond markets have reacted negatively, the U.S. Federal Reserve is expected to raise interest rates three times in 2017, and the dollar's bull run is continuing, erratically. As such it is adding to the capital flows draining from emerging markets, and to downward pressure on currencies. It is hard to see this reversing, certainly while the Bank of Japan, People's Bank of China and other central banks are committed to maintaining basically easy money policies. If there were to be a shock, it might be that expectations for Trumponomics have been exaggerated, or that the policies boost the U.S. economy initially, before pushing both the fiscal and external deficits to worrying levels.

Renminbi pressure

In China, the economy has certainly been stable, compared to the rocky period a year ago. There is no question that the government wants to keep it this way during 2017 and through the party congress, at which Xi -- as he has signaled -- wants to advance both constitutional and personal goals. The price of economic stability, though, has been an intensification of credit and fiscal stimulus measures. These are boosting China's already elevated nonfinancial debt, leading to accentuated capital outflows and pressure on the renminbi, and creating financial stability risks down the road. Investors and analysts will doubtless be following China's fractious economic and financial path with great interest.

For the wider Asia region, trade relations, as discussed, are key. So is China's economy and any competitiveness change triggered perhaps by a further decline in the renminbi. But we would expect India, which is relatively less sensitive to both, to do relatively well, provided the consequences of Narendra Modi's demonetization move in November are managed effectively. Malaysia and Indonesia should benefit from the rebound in oil prices for as long as that lasts. And Vietnam and Cambodia are still earning plaudits for picking up low-value manufacturing.

In Europe, elections in the Netherlands in February, but more importantly in France in May and perhaps in Italy at some point, will be closely watched to see if the "populist" opinion surge brings anti-EU or EU-skeptical parties to power. Brexit and Trump should have taught us humility in making predictions, and I am loath to be drawn. Suffice to say that if Marine Le Pen were elected president in France, or the Five Star Movement leads a government in Italy, the consequences would not be lost on European financial markets, the economy, or ultimately the EU's political integrity. Even if their beleaguered opponents won, we would breathe a sigh of relief but be left pondering what sort of future the EU might have if the winners are just committed to the status quo.

Overall, on first glance, the global economy does not look too bad at all. Yet, I wonder how resilient it is to the political shifts and shocks that we think of as "tail risks," but which, like Brexit and Trump, would have far-reaching consequences.

George Magnus is an economist and author of publications including "Uprising: Will Emerging Markets Shape or Shake the World Economy?"

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