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V. Anantha-Nageswaran

Any chance of the war on Iraq serving as the beacon for West Asia has diminished with divisions between the US and Europe on the idea of war itself and the rhetoric escalating on either side, by the day. It is being suggested that the US is using the Iraq issue to drive a wedge within the European community, fearing the likely dominance of an enlarged and unified Europe, says V. Anantha-Nageswaran.

SIX weeks into the New Year, the global economy appears to find no respite from the uncertainties that have bedevilled it in the last two years. If one really abstracted from data and daily developments, it is clear as daylight that global risks have only risen. The act of terror in September 2001, the response to it and the subsequent pursuit of weapons of mass destruction in Iraq have all combined to plunge the world into deeper uncertainty. The NATO alliance is in disagreement over providing cover to Turkey, and differences between the US and Europe over the appropriate course of action on Iraq, are escalating. Al Qaeda must be smiling. They seem to have achieved far more than they would have dreamt of when the two planes went into the twin towers of the World Trade Centre.

Indeed, the rift between US and Europe has the potential to undo the most optimistic of assumptions about the post-war scenario, to which even the Federal Reserve chairman has subscribed. The common belief is that if the war begins soon and ends quickly and is not followed by terrorist attacks, then the second half of 2003 would see the world pull back from the brink and that global equities could finish the year on a strong note. The future of many in the financial services industry depend on it and hence it is not entirely surprising that they believe that repeating their hopes would transform them into reality.

There is a need to examine this hope critically as a lot rides on it. There are two underlying assumptions behind the hope. One, once the war is over, it is back to fundamentals, and fundamentals are improving thanks to the ample fiscal and monetary stimulus that has been provided to world's advanced economies in recent months by policy-makers. Second, the risk premium would also decline if, after the war, there are no major terrorist attacks and the decline in risk premium would result in risky assets such as global equities, high-yielding bonds and emerging market assets gaining in value.

Fundamentals do not suggest a post-war recovery

We will take up both cases. First, it is true that once the war is behind us, it is back to fundamentals. However, those fundamentals are a long way from justifying the current earnings expectations embedded in US equity prices. Hence, refocussing on fundamentals once the war is out of the way, investors are likely to be disappointed by what they get. Merrill Lynch North American Economic Research team is quite unequivocal about this:

"We don't believe that war-or-no-war anxiety is weighing on the economy as much as many people think it is; instead, we think that it is being used as a convenient explanation for the current period of slow growth." (Source: Global Research Highlights, the Merrill Lynch View, February 14, 2003.)

Recent economic data might, on surface, appear to have strengthened the optimistic case. However, such an assessment does not hold up under further scrutiny.

On February 7, the US employment report was released. The unemployment rate dropped back to 5.7 per cent from 6 per cent in December and non-farm payroll expanded by 143,000. Workers put in more hours in January. However, not all is rosy.

In the last four months, the economy had lost a total of 25,000 jobs whereas initial indications were that the economy shed only 3,000 jobs in those four months. Number of workers who did not look for a job in the last four weeks went up from 1.4 million in December to 1.6 million and those who stopped looking for jobs at all due to various reasons were half a million from around 350,000 in December.

Retail sales for January were much stronger than expected, excluding automobiles. However, bulk of the gains came from food items. CSFB economists write that, in recent months, this category — the largest component of retail sales (excluding automobiles) — has been volatile. We are better advised against reading too much into this report. It is important to note that consumer credit has contracted in the last two months of 2002, an occurrence that has not been seen since 1992. Consumers are beginning to wake up to the reality of the debt burden that they are shouldering.

Investment spending gives way for debt reduction

Investors took heart from the continued resilience in the index for new orders in the national purchasing managers' report for January. Purportedly, it augurs well for investment spending. It does not square well with the data on durable goods orders (up to December) and with the continued job losses in the manufacturing sector.

Pricey crude oil to hurt consumer spending and economic growth

Most importantly, anticipations of lower crude oil prices in the event of a successful prosecution of war fail to reckon with the adverse impact of higher crude oil and gasoline prices that are already prevalent. West Texas Intermediate crude oil price at nearly $37 per barrel is almost close to the peak levels seen in September 2000. Retail gasoline prices are up nearly 50 per cent from the average levels of the first half of 2002.

Further, due to the low levels of petroleum stocks in the OECD countries and the limitations in the spare capacity in OPEC due to continued unrest in Venezuela, it is unlikely that the price of crude oil would quickly retreat into the low twenties once hostilities break out, as is fondly hoped for.

Therefore, an examination of fundamentals does not suggest that the war is what stands in the way of economic growth and between the end of the bear market and the beginning of a bull market in global equities.

Risk premium won't decline as apathy continues

The second major assumption is that global risk premium would decline once the Iraq issue is settled. There are two ways to tackle this assumption. One is to show that even if the Iraq issue is settled, the risk of terrorism would remain. Second, it is hard to determine how the Iraq issue could be settled without transatlantic co-operation.

Religious terrorism draws its sustenance from economic under-development which, in turn, provides recruits to the cause of terrorism. Since the unfortunate events in September 2001, the world has not moved closer to removing the umbilical chord that feeds terrorism.

The conflict between Israel and Palestine continues and the parameters of globalisation have not been explicitly redefined to include the aspirations of the developing world. A case in point is the access to low cost drugs for the developing world. While it was agreed in the Doha negotiations that drug licensing and patent regime would be relaxed, actual negotiations have been far too protracted and complex with the US holding out against any concessions. Talks broke down before Christmas in 2002. Hence, the ground remains fertile for terrorism to breed.

Transatlantic rift hurts chances of post-war reconstruction

Further, any chance that the war on Iraq would lead to a more orderly, peaceful and democratic Iraq serving as a beacon for the rest of West Asia once Mr Hussein is removed from office, has diminished with divisions between the US and Europe on the idea of war itself and the rhetoric escalating on either side, by the day. Indeed, some in the financial community argue that the US is using the Iraq issue to drive a wedge within the European community, fearing the likely dominance of an enlarged and unified Europe. It is an interesting hypothesis and one that is not to be dismissed lightly.

However, it is not clear that such an objective would really be met. There is a lot at stake for continental European countries in their union to throw it away easily.

What the division with Europe would entail for the US is that it would make post-war reconstruction in Iraq almost impossible.

Reconstruction could be starved of needed funds, and without funds, the much-needed balm to the wounded egos and pride in the region would remain unapplied. The resulting mess would leave the region more volatile than before and thus breed resentment. Thus, the risk premium, in a post-war scenario, instead of dropping, could well rise, undermining the most optimistic of assumptions. Further recriminations and bitter exchanges between the US on the one hand and France and Germany on the other, are likely to follow.

Thus, in the short-run, rising and/or high levels of risk-premium in a post-war scenario would be clearly negative for the US dollar and beneficial for Euro and gold. Thus, instead of the hoped-for reduction in risk premium, one could actually be faced with a riskier world, after the war.

What is evident in all of this is that once certain forces are unleashed, it is hard to determine their direction, speed and course.

Even global leaders are mere observers no matter how much they believe they are in control. Aggressive and inconsistent responses not backed up by a broad and inclusive vision have caused alienation. The world economy will continue to pay a price for such tunnel vision in 2003 as well.

(The author is Director of Global Economics and Asset Allocation in Credit Suisse, Asia-Pacific. His views are personal. Please send your feedback to anantha@nageswaran.com)

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