Global Pulse: Winter 2016

Instead look for the EU to try to disconnect the Greek crisis from the rest of European affairs, while continuing to keep Greece afloat with a series of stopgap measures. The fact is that the political damage that the Greek financial crisis is doing to political relations within the EU, and its impact on the rise of the “Euro-Skeptic” parties, is far more problematic that the financial repercussions of the Greek situation. The EU, at German insistence, will continue to impose harsh penalties on Greece while continuing to implement enough stopgap measures to keep the situation from spreading. The Third Economic Adjustment Program under which the EU will provide up to 86 billion Euros in additional loans in return for the Greek government implementing a range of fiscal and economic reforms will not fundamentally solve Greece’s debt problems, it will simply push off the day of reckoning so that it will become somebody else’s problem.

The second ongoing crisis in the EU is the continued problems posed by the Mediterranean and Syrian refugee crisis. From the EU’s perspective, the Mediterranean refugee issue, has been replaced by the Syrian refugee crisis. The refugee problem, however, continues to spin out of control. By the end of summer between 250,000 and 350,000 refugees will have been picked up in the Mediterranean. An additional 1.5 million to 2 million Syrian refugees will have travelled overland through the Balkans. While expanded patrols and a more forward deployment have reduced the loss of life among the Mediterranean refugees they have also encouraged more refugees to make the dangerous journey. Border closings along the Balkan overland routs are stranding hundreds of refugees in the Balkans.  Europe can simply not afford to keep absorbing these numbers of refugees, but as long as the EU continues to offer aslyum, the number of potential refugees will continue to increase and provide regular fodder for the Euro-Skeptic political parties.

The rise of the Euro-Skeptic parties and the prospect of a UK Referendum on continued EU membership will continue to play out over the course of 2016 and 2017. While a British exit from the EU is unlikely, the fact that a referendum is even being held will make it one of the top stories of 2016 and potentially into 2017.

Middle East
In the Middle East there are four primary developments that are redefining the political dynamic of the region. The first is the continued spread of violent jihadism across the region and the continuing rivalry between Islamic State and al Qaeda for the leadership of international jihadism. There have been a number of instances already where jihadist violence has been directed at European tourists in North Africa. It is only a question of time until jihadist violence spills onto the European side of the Mediterranean. The Mediterranean tourist industry, which directly and indirectly generates close to a trillion dollars in spending, is a prime target of that violence.

The second ongoing development is the increasing realignment of the region’s politics around a Sunni-Shia rivalry. Saudi willingness to respond militarily to any attempt by Shia groups to overthrow or destabilize any Sunni government, the “Salman Doctrine”, has already led to Saudi intervention in Yemen and threatens to heat up the continuing cold war between Saudi Arabia and Iran.
The third major factor transforming the region is the imminent withdrawal of sanctions against Iran. Oil exports from Iran, currently around 1.2 million barrels a day, could double very quickly to around 2.3 million and, with access to Western oil field technology, could over the next decade, double again. Moreover, Iran has over 40 million barrels of oil “stored” in tankers at sea that could quickly move to market when sanctions are lifted.

Even more significant is the release of over $100 billion in Iranian financial assets frozen by the American and various European governments. The Obama administration has already released approximately $8 billion of frozen funds to Iran. While the “semi-normalization” of political relations with Iran may ultimately lead to a less adversarial relationship with the US in the short term, it will aggravate Saudi-Iranian rivalries and may lead to more Iranian militancy in favor of Shia minorities continuing full bore in the Arabian Peninsula and elsewhere. The prospect of a nuclear-armed Iran in the near future has been overplayed. Whether that prospect, however remote, will spur a nuclear arms race in the Middle East and result in either Saudi Arabia or Turkey obtaining a nuclear capability remains to be seen.

Finally, and perhaps most significantly, is the growing realization that the international petroleum market is undergoing a sea change that will have long-term implications for the Middle East in general and for Saudi Arabia in particular. The prospect of $200 per barrel oil so confidently predicted by leading petroleum market analysts less than a decade ago is rapidly receding into a financial fantasyland.

Fifty dollar per barrel oil did not shut down American “frackers.” Cheaper oil did result in cancellation or postponement of some $200 billion of investment in high cost oil development projects. The revolution in shale oil extraction however is, a momentary hiccup notwithstanding, continuing unabated. United States oil output rose to 9.6 million barrels per day in June 2015, the highest American oil output since 1972.  Five years ago the breakeven price for “fracked oil” was around $50 per barrel. Today it is about $30 and the breakeven price continues to drop as drilling costs become cheaper and new technology and drilling techniques increases the amount of oil that can be extracted. At $50 per barrel the American fracking industry is alive and well and the opportunity afforded by tight shale hydrocarbons worldwide has barely been scratched.

Saudi Arabia has the cheapest oil production costs in the oil industry. In many fields this is substantially under $10 per barrel. The Saudi problem is not production costs however, it is revenue. Given its production levels, Riyadh needs oil prices of around $100 per barrel to balance its budget. At current oil prices, the Saudi government’s deficit is approximately 20% of GDP. Increasing production to a level sufficient to cover this deficit is not an option. For any other country a deficit of this magnitude would have precipitated a financial crisis. Saudi financial reserves peaked at around $740 billion. At current oil prices they are dropping at a rate of between $100 billion and $140 billion a year. Short term, Riyadh can weather the storm, but long term Saudi spending and oil revenues are on a unsustainable trajectory. The 40+ year oil boom that has transformed the wealth and power of Middle East oil producers is coming to an end. The party is over. Now comes the hangover.

Russia
Russian president Vladimir Putin sought to leverage Russia’s hydrocarbon wealth to reestablish Russia status as a global power, especially in the “near abroad,” the states formed from the detritus of the former Soviet Union. That dream died in the Williston basin of North Dakota. Moscow needs $100 per barrel oil to balance its budget and to provide the “guns and butter” that the Kremlin needs to maintain domestic peace and still fund its ambitious military agenda. Currently the Russian government’s deficits are running between 3% and 4% of GDP.  Officially, Russia has hard currency reserves of approximately $400 billion, but sanction induced refinancing requirements will cut that balance in half by 2017. The Kremlin can always look to monetize its deficit with ruble denominated debt but that will only add to long-term inflation concerns already aggravated by a depreciating currency.

For now, Putin insists that defense spending will stay the course. With oil supplying 70% of the Kremlin’s budget, however, and with defense and domestic security accounting for one-third of government spending, the current budgetary goals are unsustainable. The combination of long-term lower oil prices and a declining population point to a growing, long-term weakening of Russian power in the world.  Such a trend, however, might underscore a more aggressive, more defiant Russia in the short-term as the Kremlin moves aggressively to implement its foreign agenda, especially in the “near-abroad” sooner rather than later.

In the meantime, Russia has intervened militarily in Syria in order to support the Assad government in Damascus, has offered military aid to both Iraq and Afghanistan in an effort to expand its influence and has continued to attempt to increase its influence in Egypt and in the Persian Gulf. Its de facto alliance with Iran and the rest of the Shiite bloc states, notwithstanding the fact that most of Russia’s Muslims are Sunni, is reinforcing the polarization of Middle East politics along a Sunni-Shia axis..

Africa
Africa’s two major powers, South Africa and Nigeria have both been dealing with domestic unrest. In Nigeria the Boko Haram insurgency has continued, albeit at a diminished pace. The Lagos government has had more success in the last six months in containing the spread of the militant group’s ambitions. Continued jihadist inspired turmoil in Libya, Mali and Somalia, and Boko Haram’s continued activity in northern Nigeria and the surrounding area, threatens to create a zone of instability from the Gulf of Guinea to Somalia’s Red Sea coast. This instability is fueling a never-ending stream of migrant refugees across the Mediterranean. There is little if any Shia presence in Saharan and Sub-Saharan Africa, so the jihadist violence there is directed principally at African Christians, expat-European and national governments and their police and security forces.

South Africa, on the other hand, has been spared the jihadist violence that plagues the northern half of Africa, but continues to deal with rising labor militancy, persistent inflation problems and weakening world markets for much of its commodity exports. The long-term threat to Africa’s stability remains jihadist insurgencies in the north and a variety of rebel groups in central and south central Africa and their continued “warlord capitalism.” In the meantime, Chinese development funds continue to pour into Africa as Beijing attempts to expand its influence and its access to Africa’s mineral and commodity wealth.

 

South and Central America
The principal story in South and Central America is the ongoing implosion of the remnants of the late Hugo Chavez’s regime in Venezuela. Years of persistent underfunding of its capital and maintenance needs combined with declining oil prices have sharply reduced Petróleos de Venezuela’s (PDVSA) income and in the process they have also decimated the Venezuelan government’s budget.  A persistent capital flight combined with declining oil revenues have reduced Venezuela’s hard currency reserves to virtually zero. There were persistent reports over the spring and summer of 2015 that Venezuela’s central bank was either selling its gold reserves or arranging dollar swaps against its gold holdings to avert a drought of US dollars.

Persistent inflation has eroded the purchasing power of the Venezuelan bolivar to the point that most citizens would rather rely on bottles of Johnny Walker as a store of value than the country’s rapidly depreciating currency. Officially, the bolivar-dollar exchange is roughly 6 to 1; the black market rate, on the other hand, has reached as high as 423 bolivars to the dollar. Caracas continues to look to Beijing for financial assistance in return for long-term oil contracts. Given the state of Venezuela’s oil production, however, it is unlikely that Venezuela can meet its future commitments of oil to China. Venezuelan heavy crude is difficult and expensive to refine and is less desirable than other sources of oil that China has ready access to. Even Beijing may be getting to the end of its willingness to finance the Venezuelan government.

In Brazil, endemic government corruption, especially in Petrobras, the National Oil Company, persistently rising inflation and falling commodity prices are taking the luster off the Brazilian economic miracle. Of the five “BRICS” nations, two, Brazil and Russia are in recession, while the other three are experiencing a sharp reduction in their economic growth rates.

In Mexico, the principal issue remains the continued spread of drug cartel induced violence. A significant portion of the recent “progress” in bringing criminal drug gangs to justice has, it turns out, been little more than a changing of the guard as one drug gang has supplanted, often times with the complicity of Mexican security and police forces, another. The danger posed by a link up of jihadist terrorists and Mexican drug cartels has been overblown. The Mexican drug cartels have little incentive to destabilize what is far and away the largest and most lucrative market for their drugs. On the other hand the institutionalization of the drug cartels into the ruling Mexican political and administrative elite threatens to turn Mexico into a narco-state exceeding even Columbia in the heyday of the Medellin cartel. Such a development poses a long-term security risk to the United States, especially if the legalization of marijuana in various states results in an expanded presence for the Mexican drug cartels in the United States.

As in Africa, Beijing has been pouring development assistance into South America in order to gain preferential access to the regions minerals and commodities. A significant share of that developmental assistance has gone to leftist leaning regimes with a pronounced anti-Western and anti-capitalist bias. Most notably, Bolivia, Ecuador, and Venezuela. There has been rising criticisms in many of these countries at the terms of Chinese assistance, including high interest rates, a reliance on Chinese companies and imported Chinese labor to build infrastructure projects and the mortgaging of future resource exports. A change in government might well result in a repudiation of what are seen as “overly one sided, harsh and unjust terms.” This is an experience that Western companies have had before. China may soon experience the downside of investing in foreign resource development projects.

The recent thawing in US-Cuban relations will have significant long-term impact on Cuba, especially for its tourism industry, but is unlikely to have much effect on the US in the rest of Latin America or the Caribbean.

Asia
In Asia two themes dominate and both revolve around China: the state of China’s economy, especially the turmoil of its financial markets, and the realignment of the region’s security relationships in the face of China’s growing assertiveness, especially in regard to the disputed shoals and islands in the East and South China Seas.

In June, the capitalization of China’s public equity markets reached $10 trillion. Considering that 40 years ago Chinese equity markets did not exist, this milestone was a phenomenal accomplishment. In the two months that followed, however, those same equity markets experienced a sharp selloff and promptly erased some $3 to $4 trillion of investor’s wealth before recovering somewhat over the autumn of 2015. . Beijing has intervened aggressively and has succeeded in stabilizing its financial markets, but so far it is unclear whether it will succeed in doing this over the long term. In the meantime, China continues with the long-term consequences of an overheated housing market, an economic development model that still relies on infrastructure and industrial development to drive economic growth and a consumer sector that is still too small to be a reliable driver of economic growth.

Attempts to shift the locus of new investment away from the coastal cities to the interior are having mixed success. There has been a significant pickup in investment further inland, but most of this activity is still within a 200 mile band from the coastal cities. The transportation infrastructure to permit a more balanced development of China’s interior is still not present. In the meantime, the urbanization of China’s major cities continues unabated. That urbanization will continue to drive China’s demand for basic commodities, current weakness notwithstanding, and remains a critical element of China’s continued economic growth but at the risk of future aggravating the balance, and the economic wealth, between China’s big cities and the rural interior.

In the meantime, China’s increasing military assertiveness in its periphery is driving de-facto, if still unofficial, security alliances between historic enemies. Japan and the Philippines have announced, for the first time, joint military exercises in the South China Sea and an ongoing rotation of Japanese military personnel for joint exercises and training on Philippine soil. This is the first long-term presence of Japanese military forces in the Philippines since the end of World War II. Likewise, Vietnam has been increasingly looking to the United States to bolster its security against what is perceives as growing Chinese aggressiveness. This cooperation may soon result in renewed US Navy access to the former US military facilities at Cam Ranh Bay.

Less