investor’s interest in hedging tail risk is growing

• “TAIL-RISK” hedging was the talk of Wall Street in 2008 after global markets nosedived and traumatised investors tried to figure out how they could protect themselves from extreme or “black swan” events—those well outside an ordinary distribution of outcomes—that cause massive losses. Interest is revving up again as revolutions in the Middle East and Japan’s earthquake have destabilised markets and increased volatility, leaving battered investors searching anew for protection.
• Peddlers of tail-risk products like to compare them to insurance: investors pay premiums every year to avoid financial catastrophe later. Some even get philosophical. Vineer Bhansali of PIMCO, a big fund manager, has likened tail risk to Pascal’s wager—the argument that you’re better off believing in God than suffering the consequences of being wrong. The same is true with drastic dives in markets.
• Tail risk is technically defined as a higher-than-expected risk of an investment moving more than three standard deviations away from the mean. For mere mortals, it has come to signify any big downward move in a portfolio’s value. There are different ways to hedge tail risk, but a popular one is to create a basket of derivatives that will perform poorly during normal market conditions but soar when markets plunge. These include options on a variety of asset classes, such as equity indices and credit-default-swap indices.
• Some banks have started to sell tail-risk products. Deutsche Bank has created the ELVIS index, which generates returns when stockmarket volatility increases. Big asset managers like BlackRock and PIMCO have made a business of advising customers on managing for the worst case. Hedge funds have also got in on the act. Several “tail funds”, which invest in assets that should rise in bad economic times, have started up in the past few years. These funds tend to lose around 15% each year when the market is normal but can return 50-100% when the market dives. Or more: 36 South, a hedge fund, saw its tail fund gain 234% in 2008. According to Gaurav Tejwani of Pine River, which launched a tail-risk fund last year that now manages over $200m, “It costs money in most good years or average years, but it makes you a fairly large return when all your other assets are performing very poorly.”
• Sellers naturally claim it is worth the cost. Mr Bhansali of PIMCO, which offers several tail funds, estimates that it costs investors between 0.5% and 1% of assets to hedge against tail risk, but that investors will break even in three to five years. That is partly because the market does not have to crash in the way that it did in 2008 for hedges to pay their way. PIMCO now oversees around $30 billion in tail-risk products, mostly in separate accounts. Other funds have also seen inflows. Take, for example, Universa Investments, a tail fund advised by Nassim Taleb, author of “The Black Swan”, which has grown from $300m in 2007 to around $6 billion today.
• Even so, Mark Spitznagel, the boss of Universa, complains about complacency among investors. Demand is very uneven. The price of hedging varies, rising when markets are volatile and investors most need it, and declining during bull markets. It is difficult, after all, to keep stomaching losses from hedged positions as markets rise: “The kids outside playing in the snow without sweaters and scarves seemed to have much more fun than those of us who were bundled up,” says Steven Englander of Citigroup.

economic and financial indicators:overview

• British inflation quickened to 4.4% in February from 4% in January. The main forces pushing it up were higher domestic heating bills (which increased because of the jump in world energy prices) and a rise in the prices of clothes and shoes.
• The euro area’s trade deficit with the rest of the world soared to €14.8 billion ($19.8 billion) in January from €0.5 billion in December 2010.
• New Zealand’s economy grew by 0.4% in the fourth quarter, after a contraction of 0.3% in the three months to September. Growth in the year to the fourth quarter was 1.4%.
• Citing concern over rising inflation, the Reserve Bank of India raised both of its policy rates by a quarter of a percentage point on March 17th. The rate charged on loans to commercial banks was increased to 6.75%, and the interest rate paid to banks was pushed up to 5.75%.
• Inflation in Hong Kong quickened to 3.7% in February, a 30-month high and a tenth of a percentage point higher than January’s rate.
• Industrial growth in Taiwan slowed to 13.3% in the year to February from 17.4% in the year to the previous month.
• Japan’s service industries grew by a seasonally adjusted 2.1% in January. The charts below show Japan’s GDP growth, recent trends in exports and in the real exchange rate, as well as which countries rely most on exports to Japan.

investors have gone off India

• Corruption is dreadful in India, as shown by a current “season of scams”—over mobile-phone licences, the Commonwealth games and more. Politicians, notably the ruling Congress party, are now feeling the public’s ire. Worries have also grown that graft is scaring away foreign businesses.
• Circumstantial evidence points that way. A spokesman for a big Western firm mutters into his cappuccino about a recent High Court decision, which if upheld would cost his company billions. It was so strange, he says, it could be explained only by judicial graft. A representative of a British media firm, SIS Live, which broadcast the Commonwealth games from Delhi, in October, is furious—along with other contractors—at being left millions of pounds out of pocket because, he says, payments have been frozen by investigators digging up evidence of corruption at the event.
• Across the board, surveys regularly tell how graft is an unusually heavy tax on Indian business. An annual one published on March 23rd by PERC, a Shanghai-based consultancy, shows investors are more negative than they were five years ago. Of 16 mostly Asian countries assessed, India now ranks the fourth-most-corrupt, in the eyes of 1,725 businessmen questioned. Being considered worse than China or Vietnam is bad enough; being lumped with the likes of Cambodia looks embarrassing.
• Outsiders may get an exaggerated view. India’s democracy, with a nosy press and opposition, helps to trumpet its scams and scandals, more than happens in, say, China. Yet locals tell similar tales. A cabinet minister frets that there is so much ghotala(fiddling), “it tells the world we are all corrupt. It may be a dampener to investment.” Others agree. KPMG this month reported on 100 bosses who were asked about their own experience of graft. One in three said it did deter long-term investment.
• Judging how much difference it makes is tricky. Right now, investors may be spooked as much by the fight against graft as by the corruption itself. Arpinder Singh of Ernst & Young in Mumbai says foreigners, especially those with some connection to America, increasingly hire firms like his to help them comply with America’s Foreign Corrupt Practices Act. Once a foreigner holds more than about 5-10% equity in an Indian firm, it is seen as having some responsibility for how it is run.
• Now even Indian firms, if they want to raise money abroad, or if their bosses want to protect their own professional reputations, are doing the same. As other countries, such as Britain, bring in tough anti-graft laws like America’s, the trend will continue. Yet many Indian firms still fail to comply with higher standards, so deals falter. Mr Singh ticks off a list, “in infrastructure, ports, toll roads, irrigation, microfinance”, of deals he has worked on that collapsed over “governance problems”.
• None of this is enough to prove that graft, alone, is scaring off business. Pranab Mukherjee, the finance minister, insists there is no correlation between corruption and foreign direct investment (FDI). Jeffrey Immelt, the boss of GE, in Delhi last week, cheerily agreed, insisting that a fast-growing market trumps all other concerns.
• But something is keeping investors wary. In 2010 the country drew just $24 billion in FDI, down by nearly a third on the year before, and barely a quarter of China’s tally. There is no shortage of other discouragements: high inflation, bureaucracy, disputes over land ownership, and limits on foreign ownership in some industries.
• Even so, India is home to an unusually pernicious form of corruption, argues Jahangir Aziz of JPMorgan. Elsewhere graft may be a fairly efficient way to do business: investors who pay bribes in China may at least be confident of what they will get in return. In India, however, too many crooked officials demand cash but fail to deliver their side of the bargain. Uncertainty, not just the cost of the “graft tax”, may be the biggest deterrent of all.

another year of living dangerously

• This was supposed to be a stress-free year for the global economy. By January the financial crisis had faded and Europe’s sovereign-debt crisis seemed less acute. America’s economy was resurgent. Investors piled into equities and sold some of the government bonds they’d bought for troubled times. If there was a worry, it was that emerging economies would grow too quickly, inflating commodity prices.
• The year without crisis is not to be. First, Arabian upheaval put oil markets on edge. Then earthquake, tsunami and a nuclear accident clobbered the world’s third-largest economy. How much of a setback to growth do these twin crises represent? And how should economic policymakers react to them?
• Japan’s share of world output has been shrinking for decades, but at 9% it remains large enough for the hit to the country’s growth to subtract noticeably from global output. Then there are the ripple effects on the rest of the world. Japan is a large—in some cases the sole—supplier of intermediate goods to the world’s electronics and automotive industries, from the hardened glass on Apple’s iPad to gearboxes in Volkswagens. Many makers of such parts have had to slow or halt shipments because of damaged roads, power cuts or the loss of components from their own suppliers. The effects have spread well beyond Japan, causing shutdowns from South Korea to Spain. Still, the history of such disasters is that much of that lost production is eventually recovered and reconstruction delivers a fillip to subsequent growth.
• Pinpointing the impact of Arab political turmoil is complicated by the fact that oil prices were already rising thanks to a brighter global economic outlook. Nonetheless, a good portion of this year’s 25% increase seems due to worries over supplies. A rule of thumb holds that a 10% increase in the price of oil trims 0.2 percentage points from global growth. At the start of the year, the world looked likely to grow by 4-4.5%. A crude estimate is that the two crises will subtract between a quarter and half a percentage point from that.
• That may not capture the full effect. Crises by their nature generate clouds of uncertainty . Businesses postpone capital spending and hiring until the clouds clear. Investors seek the safety of bonds and lose their taste for equities.
• Economic policymakers can’t make peace between Arab rulers and their people or stabilise Japan’s nuclear reactors, but they can minimise the collateral damage. The greatest burden is on the Bank of Japan. Its efforts to cure deflation over the past 15 years have too often been timid. That could not be said of its rapid response to the tsunami. It poured cash into the banking system in a pre-emptive strike against panic hoarding. And it expanded its purchases of government and corporate debt and equities. Still more “quantitative easing” can keep bond yields from rising as the government borrows for reconstruction, and help the fight against deflation.
• What should the rest of the world do? In a show of sympathy the G7 joined the Bank of Japan in selling the yen after it spiked dramatically. Such actions should be limited, however. Japan is too dependent on exports and its priority should be stimulating domestic demand and ending deflation, not cheapening the yen. A better way for outsiders to help is to ensure that concerns over radiation in Japanese products do not become an excuse for protectionism.
• Other central banks face a more complicated task. Even as higher oil prices and hobbled Japanese production reduce growth they add to mounting inflation risks (Britain is now fretting over inflation of 4.4%). But most rich-world economies have ample economic slack, and in several countries fiscal tightening will tug at recovery. Britain’s coalition government has reaffirmed its commitment to austerity with this week’s budget , and America has begun to cut spending. Both the Bank of England and the Federal Reserve should resist the temptation to tighten soon.
• The European Central Bank seems intent on raising interest rates next month. That would be a mistake. In the euro zone underlying inflation and wage growth are both subdued and inflation expectations are under control. By raising rates the ECB would strengthen the euro and frustrate the efforts of countries like Greece, Ireland and—the next in line for bailing out—Portugal to grow their way out of their debts.
• There is only so much economic policymakers can do about crises that spring from war or nature. In this case, the priority should be not making matters worse.

happy china

• The pursuit of happiness, runs one of the most consequential sentences ever penned, is an unalienable right. That Jeffersonian sentiment seems to have influenced even China’s normally strait-laced, rubber-stamp legislature, the National People’s Congress (NPC), which has just wrapped up its annual session. Increasing happiness, officials now insist, is more important than increasing GDP. A new five-year plan adopted at the meeting has been hailed as a blueprint for a “happy China”. The prime minister, Wen Jiabao, however, appeared downright miserable as he described the challenges he faces.
• At the end of the ten-day meeting, Mr Wen told journalists that his remaining two years in office would be “no easier” than the preceding eight. Keeping the “tiger” of inflation in its cage would be hard enough, he said (the NPC approved a target of 4% this year, compared with inflation of nearly 5% in February). But corruption was the “greatest danger”. A few days before the session began, the railways minister, Liu Zhijun, had been dismissed in connection with a huge bribe-taking scandal.
• The five-year plan called for 7% annual average growth in GDP between now and 2015, compared with a far-exceeded target of 7.5% set in 2006-10. Mr Wen said lowering growth without raising unemployment would be an “extremely big test”. But, he said, China had to change its pattern of economic growth, because it was (using a hallmark phrase) “unbalanced, unco-ordinated and unsustainable”.
• The idea of promoting happiness spread over the country like a huge grin early this year when provincial governments began laying out their own five-year plans. Guangdong province declared it would become “happy Guangdong”. Beijing (which is a province-level administration) said it wanted its citizens to lead “happy and glorious lives”. Chongqing municipality, another province-level area, said it wanted its people to be among the happiest in the country. Officials now often talk of setting up “happiness indices” by which government performance should be judged.
• The word’s popularity among bureaucrats is more an attempt to please leaders in Beijing and show sympathy for the less well-off than a sign of any real determination to change their ways. Many lower-level governments have continued to set investment-driven GDP-growth targets that are far higher than Mr Wen’s. Some of his goals, such as building another 36m subsidised homes by 2015, will require the co-operation of local governments. They are adept at evading such tasks.
• Mr Wen does not see political freedom as having much to do with happiness. In August last year he raised hopes among some liberal-minded intellectuals when he made a flurry of statements about the importance of political reform. Since then, the repression of dissidents has been stepped up. Dozens have been rounded up or put under surveillance in order to prevent them from responding to anonymous internet-circulated calls for an Arab-style “jasmine revolution” in China. To deter any protests, police security during the NPC was even heavier than usual.
• At his press conference, Mr Wen repeated some of the language he had used last August on the need for political reform. This included a warning that China’s economic gains could be wiped out if the country failed to reform politically. He also said people needed to be able to “criticise and supervise” the government. But he offered no guide to how this should happen, and stressed the need for change to be “gradual”, “orderly” and “under the leadership of the party”. He said it would be wrong to draw comparison between the situations in the Middle East and north Africa and that of China.
• The NPC’s chairman, Wu Bangguo, went further, telling delegates that the country faced an “abyss of internal disorder” if it strayed from the “correct political orientation”. He also declared China had achieved its goal of setting up a “socialist legal system with Chinese characteristics”. The Communist Party said in 1997 that it would do this by 2010, but never made it clear how progress would be assessed. China’s struggling band of independent lawyers, who are often spurned by courts and harassed by police for trying to defend victims of official wrongdoing, are probably not celebrating.
• The government’s crackdown on dissent apparently includes a strengthening of China’s internet firewall to make it more difficult to use software to evade blocks on sensitive foreign websites. Some websites in China recently carried a report that 11% of respondents to an opinion poll believed national happiness is boosted when they express themselves freely on the internet. If only they could.

How the euro-zone outs are fighting to retain influence in the European Union?

• One fear of European Union members outside the euro, either by choice or because they are not ready to join it, has been that they will be cut out of the big decisions being taken in Brussels. One hope of many of the euro’s founder members was the obverse: that the club would become more politically and economically integrated. That original tension between wide consultation and tight integration is now bubbling over in arguments over whether the euro-zone heads of government should have regular summits.
• Poland, a leading euro “out”, was horrified when a leak revealed internal German correspondence on the “competitiveness pact” proposed by Chancellor Angela Merkel and the French president, Nicolas Sarkozy. This confirmed the danger of a two-speed Europe that locked out non-euro countries and sidelined the European Commission. Yet Poland sees Germany as its best friend in the EU.
• The Polish prime minister, Donald Tusk, made his dismay thunderingly clear. He has got somewhere as a result. “At the European Council, Tusk never gets angry; he’s trusted and a credible negotiator,” says Piotr Kaczynski of the Centre for European Policy Studies in Brussels. “So on the occasion when Tusk does shout, Brussels stops.” The compromise “pact for the euro” makes concessions, including a role for the commission.
• The Poles will continue to fight plans to move decision-making from the 27 to the 17, accepting the smaller group only for matters directly related to the euro. But they like the competitiveness pact’s structural reforms, such as reforming wage indexation. Jacek Rostowski, the finance minister, says “it’s good if all Europe wants it, not just something for emerging economies.” And there is some scepticism about the ability of 17 very different euro-zone countries to agree on new policies.
• Poland plans in principle to join the euro. The fear of isolation is keener in Denmark and Sweden, which want more say but are unlikely to join the single currency for a while. The adoption of the euro by such new members as Slovenia, Slovakia and now Estonia was a reminder of their dwindling influence. “It really rankles that they can’t get into important policy meetings,” says an Estonian diplomat.
• In fact the centre-right coalitions of Sweden and Denmark, unlike their counterpart in Britain, are eager to adopt the euro. But their voters are not persuaded. The Danes have twice voted against joining, once in a referendum on the Maastricht treaty in 1992 and again when they were asked to reconsider in 2000. Swedish voters similarly rejected the euro in a 2003 referendum. Now the risk of a two-speed EU, with Sweden and Denmark in the outer lane, has led to speculation about fresh referendums in both countries.
• The Danish prime minister, Lars Lokke Rasmussen, floated the possibility earlier this month, arguing that Denmark should ratchet up its European commitment before it takes over the EU’s rotating presidency next January. But the timing could hardly be worse. One opinion poll in February suggested that voters might agree to scrap their opt-outs (from judicial and security co-operation as well as the euro) only if all three were dealt with in a single referendum. And this was a rare positive blip in an anti-euro trend. A December poll by Denmark’s Danske Bank found fully 43.5% were definite noes and only 25.5% certain yeses—an 18-point lead. “I don’t believe the prime minister will call a referendum; the risk of a no is too high,” says Steen Bocian, the bank’s chief economist. Another complication is that Denmark must hold a general election by November—and Mr Lokke Rasmussen is trailing in the polls.
• The travails of the single currency have hardened anti-euro sentiment in Sweden too. Danes fear that without the krone they might have sunk into an Irish quagmire. Swedes are proud that their economy has thrived on the outside. Far from being in the slow lane, in the fourth quarter of 2010 it was the fastest-growing in the EU. For now, Sweden and Denmark will remain out. Their governments will back Poland in resisting a bigger role for the euro group.
• On the face of it, the prospect of regular euro-zone summits is a setback also for Germany. Economic government was a French idea, loaded with dirigiste menace and peril for the independence of the European Central Bank. Mrs Merkel has always been the sworn enemy of class distinctions within the EU. In 2008 she rejected calls for a two-speed Europe when Irish voters rejected the Lisbon treaty. “The unity of Europe is not something we want just for its own sake,” she declared. “It is a great good.” Moves in the direction of a euro-zone economic government look like a climbdown.Mrs Merkel would deny this. No new club is being formed, and any arrangement cooked up by the 17 will be open to the ten non-euro members as well. Far from opening a dangerous new division within the EU, the Germans think they are closing one: between competitive economies and the laggards that threaten the survival of the euro. If they have their way, this euro-zone summit may be the last.
• From Mrs Merkel’s point of view, the alternative was worse. Germany may have as much as €200 billion ($280 billion) of exposure to rescue schemes for wobbly euro members and that figure could climb. So will resistance from voters and some members of Mrs Merkel’s coalition. The euro has become the top political issue, says Frank Schäffler, a hawkish Bundestag member from the liberal coalition party, the Free Democrats. The pact for the euro is supposed to help by breaking euro countries of the bad economic habits that got them into trouble in the first place. “She needs something to take to her increasingly sceptical coalition,” observes Daniela Schwarzer of the German Institute for International and Security Affairs. Not all are reassured. Mr Schäffler sees the pact as a “placebo to quiet the people.” European countries should compete rather than being forced to reform by a central authority, he thinks. Hans-Werner Sinn, a liberal economist, fears that France may use a euro-zone government to force Germany to raise wages.
• Mrs Merkel’s allies are awkwardly positioned between backing her diplomacy and setting limits on German concessions. On February 23rd the three coalition parties laid down conditions for approving a treaty change to set up a permanent euro-zone bail-out fund. One was more economic co-ordination within the zone—in other words, a version of the competitiveness pact and its embryonic economic government. Mrs Merkel may have long opposed a two-speed Europe, but pressure from voters, her coalition partners and other euro-zone countries seems to be pushing her into tolerating it.

Financial crises and property busts go together

• Property’s grip on people is unrelenting. After the worst housing crash in memory, almost two-thirds of Americans still think that property is a safe investment. In Britain ministers hold summits to work out how to get first-time buyers into a market where prices are falling. In China anxious buyers queue to snaffle yet-to-be-built apartments. The world of commercial property is saner, but not by much. A bounceback in office values in London has prompted fears of a new bubble. Cranes dot the Chinese skyline, where more than 40% of the skyscrapers to be built over the next six years will be sited.
• Property is more than just a place to live and work. For many people, it is the biggest financial bet they will ever make. That bet has been disastrous for plenty of homeowners. Over a quarter of mortgage-holders in America owe more on their loans than their homes are worth. House prices there have fallen back to 2003 levels and are still declining—by 2.4% year-on-year in December. A huge pipeline of foreclosed homes is still on its way to market: distressed transactions account for 66% of sales in California. Prices will probably fall again this year, sapping confidence and preventing people from moving to find work. Programmes to modify mortgage payments have been disappointing: for some underwater borrowers it may make more sense for the state to help reduce the principal.
• At least prices in America are back to their long-run average compared with rents. For those with cash, homes are more affordable than they have been for years. In many parts of Europe, prices still have a long way to fall to revert to that sort of value and there is lots of downward pressure. Oversupply weighs on the market in places like Spain, where a construction boom turned to bust. Credit is constrained (a big worry for commercial property, too, given the amount of debt that needs to be refinanced). The threat of rising interest rates looms over the many borrowers with adjustable mortgages.
• In emerging markets policymakers have a different problem: holding prices down. A property bubble, many reckon, is the biggest threat to China’s economy. A succession of measures have been introduced to subdue speculative buying and force developers to increase the supply of homes. There are sound reasons for prices to rise in China, given income growth and huge pent-up demand for decent housing. But policymakers are having to fight to keep things under control.
• The irony is that property’s appeal is founded on its supposed solidity. It is no coincidence that the housing bubble started in the aftermath of the dotcom bust. Out went fantasy business plans; in came a real asset with a proven record. But , property has dangerous qualities.
• One is its size. American households have more of their wealth in real estate than any other asset; it is a similar story elsewhere. So when things go wrong, the consequences are more serious than if there is a slump in equities, say. Worse, property is a magnet for debt. Lenders have to set aside less capital for loans against property because of its security as collateral. Individuals have no other opportunity to take on so much leverage. As prices go up, a deadly feedback loop forms: rising collateral values enable banks to extend more credit, which means prices can be chased higher. Things can spiral very quickly: there was a doubling of mortgage debt in America between 2001 and 2007. It is leverage that explains why property busts have a habit of causing financial crises.
• Property is also an inefficient asset class. It is lumpy: you can offload parts of your share portfolio, but you cannot sell off the kitchen. It is illiquid, which can strand people in their homes even if they are not in negative equity. And it is inefficiently priced, not least because as an asset class it is hard to short: you can’t hedge your exposure.
• So governments should be neutral about home-ownership, whose benefits have been oversold. People will always want to buy houses: they do not need a shove from subsidies. In America plans to wind down Fannie Mae and Freddie Mac, which buy and guarantee mortgages on the government’s account, are welcome. Tax deductions on mortgage interest should go. So should distorting exemptions on capital-gains taxes; it is better to cut the transaction taxes that make it expensive for people to move.
• Politicians will be loth to cut the value of their electorate’s biggest asset, however. Which is why lots of people are now looking to central banks to intervene when property booms get going. That already happens a lot in Asia; Western central banks are also moving in this direction. The Swedes last year imposed a maximum loan-to-value ratio of 85% on mortgages, for instance. Good. Standing idly by is not much of a policy. And central banks have tools at their disposal, including interest rates, that can dampen things down.
• Regulators have failed to spot bubbles in the past, however. And booms can be hard to stop when they get going: just ask the Chinese authorities. Discretionary interventions should be on top of standing rules, not instead of them. There should be no room for the wildest mortgage products—those that do not seek verification of income, say. But the systemic issue is the amount of debt that borrowers take on. Property busts are at their most destructive when borrowers fall quickly into negative equity (one reason to worry less about China is the small amount of debt that homebuyers have). A cushion of equity—10-15% of the property’s value, say—should be required of new borrowers as a matter of course.
• This should be phased in gradually. Unlike getting rid of mortgage interest relief, which is relatively painless when interest rates are already low, a minimum equity provision would hurt the economic recovery (especially in America, where the government is guaranteeing loans with tiny down-payments). And there is also a risk of excluding creditworthy borrowers, particularly first-time buyers and the self-employed. But it cannot wait too long. Asking people to save up for longer is a reasonable price to pay for a safer system.

A complex chain of cause and effect links the Arab world’s turmoil to the health of the world economy

• Two factors determine the price of a barrel of oil: the fundamental laws of supply and demand, and naked fear. Both are being tested by the violence that is tearing through Libya, the world’s 13th-largest oil exporter. The price of a barrel of Brent crude now hovers around $115. On February 24th, however, it rose to almost $120, as traders realised that they might have to do for a while without some or all of Libya’s exports: some 1.4m barrels a day (b/d), or about 2% of the world’s needs.
• The situation in Libya is grim, as the rebels and the forces of Muammar Qaddafi battle for control of the country’s only resource. Brega, the seat of the Sirte Oil Company in the east of the country, has changed hands three times in recent days. Most of the oil workers have fled, and production has fallen by two-thirds. The ports of As Sidra, Brega, Ras Lanuf, Tobruk and Zuetina, which together handle almost 80% of Libya’s oil exports, were all seized by the rebels; two have now been retaken by Colonel Qaddafi’s forces. The rebels remain in control of Africa’s largest oilfield, Sarir, pumping some 400,000 barrels on a normal day. But for how long?
• The history of oil is marked by Middle Eastern strife, supply shocks and global recession, with the Arab oil embargo in 1972, the Iranian revolution in 1978 and Saddam Hussein’s invasion of Kuwait in 1990. To gauge the risks today you need to answer three questions. How vulnerable is the oil market to an interruption in supply? How sensitive is the world economy to oil-price spikes? And how well can policymakers cope with a shock if the worst happens? Take each in turn.

• The troubles in Libya are only the most serious example of the impact of Arab unrest on global oil markets. Prices jumped as Egypt’s citizens took to the streets to oust President Hosni Mubarak. Egypt is an oil importer, but acts as a vital conduit between the huge oilfields in the Persian Gulf and markets in Europe, via the Suez Canal and through the SUMED pipeline. Although it seemed unlikely that protesters would or could disrupt oil shipments, events in Cairo were enough to add more than $5 to a barrel.
• The spread of unrest to Bahrain, Oman and the Gulf has created a whole new dimension of anxiety. North Africa produces 5% of the world’s oil, but the Middle East produces 30%. Moreover, Bahrain’s problems are on Saudi Arabia’s doorstep. These bear on the situation in the eastern Saudi provinces, from which a huge quantity of oil is pumped into global markets.
• Saudi Arabia is therefore the traders’ chief worry. But it is also, in oil terms, the world’s chief hope. It is the only producer with significant spare capacity that could quickly be released if the oil price rose too high. Although OPEC, in which Saudi Arabia is the biggest force, exists to keep oil prices buoyant, it does not want to see them reach a point where the world economy is damaged and demand for oil falls. When prices spiked in 2008, the Saudis said they had capacity to spare. Terrified oil markets doubted its existence, and prices rose anyway, to reach $145. Yet the subsequent collapse in the oil price in the second half of 2008 was only partly caused by the credit crisis and the rich-world recession that resulted. Saudi Arabia also pumped extra oil: nearly 2.5m b/d on top of the 8.5m it was already providing.
• OPEC’s spare capacity now is put at anything between 6m b/d (by OPEC) and 4m-5m b/d (by industry analysts); Saudi Arabia’s share of that excess is perhaps 3m-3.5m b/d. The oil price has retreated from its peak in the past ten days largely because Saudi Arabia says it is pumping up to 600,000 b/d to replace the shortfall in Libyan exports. It has invested heavily in expanding capacity, with plans to spend perhaps $100 billion on wells and infrastructure by 2015. It has also been far more open about letting the world see what it has done. OPEC’s stated aim of stabilising oil prices relies on traders believing that the Saudis really do have the capacity to pump more when prices rise.
• Why, then, are traders still so nervous? The answer is that the long-term trends of supply and demand were already unfavourable when the Arab shoe-throwers intervened. Before the uprisings, a barrel of Brent crude was commanding close to $100 a barrel. World demand grew by an extraordinary 2.7m b/d in 2010, according to the International Energy Agency. It will probably keep growing by another 1.5m b/d this year and the same again next, as the rich world recovers and demand surges in China and the rest of Asia. Net expansion of non-OPEC supplies is likely to be negligible in the coming years. Though the rich world’s inventories are high, with cover of around 50 days, it is not clear that Saudi Arabia can pump much more than it did in 2008; and the speed of oil released from government reserves, such as America’s Strategic Petroleum Reserve, also has upper limits.
• If disturbances hit Algeria and threaten its oil industry too, the buffer of spare capacity would fall below where it stood in 2008. But demand now is much higher, so spare capacity as a proportion of that demand is much lower.
• When oil markets tighten, another set of problems emerges. Saudi oil is generally more dense and sulphurous than the Libyan crude it will replace. Europe’s creaky old refineries will not be able to process the heavier Saudi crude, and fuel regulations there are less tolerant of sulphur content than elsewhere in the world. So the Gulf oil will have to be shipped to Asia’s newer refineries, which are designed to deal with a wide variety of grades of oil. West African oil, a close substitute for Libya’s output which usually goes to Asia, will be sent to Europe instead.
• If the supply situation worsens, opportunities for this type of substitution will be fewer, creating supply bottlenecks, shortages of petrol and spikes within price spikes for different crudes and products, even when spare capacity remains. The price differential of about $15 a barrel that has built up between Brent crude, which more closely reflects global trade, and West Texas Intermediate, the benchmark for oil prices in America, is a good example of how oil markets can become distorted by local patterns of supply and demand. If supply gets even more stretched, oil could fetch a far higher price in some parts of the world than others. If supply problems become really grave, oil companies may even declare force majeure, raising the prospect that, as in 1978, oil markets fail altogether.
• That is still a remote prospect, and the upward march of the oil price seems to have paused for now. The crucial question is how much oil will be lost, and for how long. When oil markets operate at the limits of supply, even the smallest extra disruption has a disproportionate effect. On February 26th, for example, Iraq’s biggest refinery shut down after a terrorist attack. This and other assaults could knock out another 500,000 b/d from the world’s fuel supplies. And if the raids on oil installations in previous elections in Nigeria are anything to go by, the next one, in April, may threaten another 1m b/d of supplies from west Africa. Meanwhile, Saudi Arabia remains far from secure . On March 1st the country’s stockmarket, jittery about the neighbours, plunged by 7%, a worrying sign that confidence is fading.
• All this is a dark cloud on an otherwise bright horizon for the global economy. Few things can short-circuit growth like an oil shock, both because of the fuel’s ubiquity and because of the relative insensitivity of demand. When the oil price jumps, consumers have little choice but to accept it, spending less on something else.
• So how sensitive is the world economy to oil prices? Thus far the rise, and the likely damage, both look modest, in part because many forecasters had expected an increase this year anyway. Since the end of last year the price of Brent has risen by $23 a barrel, or about 25%, and West Texas Intermediate by $10, or 10%. The IMF reckons that a 10% increase in the price of crude shaves 0.2%-0.3% off global GDP in one year. As it happens, crude oil (using a blend of several grades), is now about 10% more costly than the IMF assumed in late January, when it projected global growth of 4.4% this year. That implies that the Fund would now foresee growth of about 4.2%.
• Economists do not expect a repeat of the 1970s, when oil-price rises led to “stagflation” in the rich world. Olivier Blanchard, chief economist of the IMF, and Jordi Galí, of the Centre de Recerca en Economia Internacional in Barcelona, point out that two recent oil-price rises—one beginning in 1999 and another in 2002—were of the same order of magnitude as during those turbulent years. But the effect on both inflation and unemployment in the rich world was much smaller: in America, for example, a rise in inflation of only 0.7 percentage points on average, whereas the 1970s shocks had caused a rise of 4.5 points in the two years after the shocks.
• The rich world is less vulnerable now because it has substantially reduced the amount of oil used per unit of output. America’s economy in 2009 was more than twice as large in real terms as in 1980. Yet over that period America’s oil consumption rose only slightly, from 17.4m b/d to 17.8m. Europe actually used less oil in 2009 than in 1980, even though its economy had grown.
• Other factors may also have helped. Supply shocks generate larger increases in inflation and bigger falls in output when wages are rigid. So oil shocks have smaller effects today, because labour markets in rich countries have become considerably more flexible since the 1970s.
• Emerging economies may be hit harder by a spike, since they use more oil per unit of output than rich countries do. America’s economy, though about three times the size of China’s, uses just over twice the amount of oil that China’s does. But oil intensity in emerging countries has also been falling in recent years, as manufacturing has become more efficient and less energy-intensive service industries have increased their share of the economy. So even these countries are less vulnerable to an oil shock than they used to be.
• Among rich economies America tends to suffer the biggest immediate impact, because its economy is relatively energy-intensive and because its low petrol taxes interpose only a small wedge between crude oil and petrol prices. Goldman Sachs estimates that a 10% price increase trims GDP by 0.2% after one year, and 0.4% after two.
• In Europe the effect is muted by lower energy intensity and high levels of tax. Excise and value-added tax represents roughly 60% of petrol prices and 52% of diesel prices in the euro area, according to the European Central Bank (ECB).
• Emerging Asia is more complicated. Although its economies are more oil-intensive, several also export oil, and many subsidise fuel, limiting the impact on consumers. Thailand has resolved to hold the price of diesel below 30 baht (about $1) a litre until April; without the subsidy, which was raised on February 24th, it would be 34 baht. Citigroup estimates that each $10 increase in the price of oil costs India’s state-owned oil-marketing companies the equivalent of 0.5% of GDP, of which half is absorbed by the budget. An IMF staff study has estimated that emerging and developing countries subsidised fuel by about $250 billion in 2010.
• What can central banks do to protect the economy? Higher oil prices act as a tax on countries that import the stuff, which would normally call for easier monetary policy. But they also raise inflation, which calls for tightening. A one-off rise in prices would not produce a sustained increase in inflation, unless it boosts firms’ and workers’ expectations of future inflation, which can become self-fulfilling. The oil-price shocks of the 1970s rapidly found their way into broader inflation. Central banks had to clamp down drastically to suppress their inflationary effects.
• In recent years, with inflation expectations more stable, central banks have responded more moderately to higher oil prices. But in July 2008 the ECB raised short-term interest rates because it feared that a rise in headline inflation would feed a wage-price spiral. In retrospect, that was a mistake. The global economy was already slowing, and over the next year both headline and core inflation (which excludes energy) fell sharply in the euro zone. Although America’s Federal Reserve did not tighten, it hinted at the possibility, which prompted markets (wrongly) to anticipate a rate increase. These hawkish signals may have compounded the slide in economic activity already under way.
• This year their response is likely to be more subdued. Unemployment is higher in America and Europe than in 2008, and underlying inflation, except in Britain, is lower. At a forum on February 25th at the University of Chicago, officials from both the European and American central banks signalled willingness to hold fire unless inflation expectations grow. On March 1st Ben Bernanke, chairman of the Federal Reserve, said the recent rise in commodity prices would probably “lead to, at most, a temporary and relatively modest increase” in inflation.
• In many emerging markets the risks are greater. Those economies are already operating at capacity, and both overall inflation and core inflation have risen: China’s January inflation rate was 4.9%, well above its official 4% target, and India’s was more than 9%. An increase in the price of energy can cause a steeper jump in inflation in emerging markets, because in many it has a larger weighting in their consumers’ baskets: 15.2% in Indonesia, 14.2% in India and 13.8% in Malaysia, compared with about 9% in America’s. Moreover, energy is a large input in food production, which has an even bigger weight.
• Monetary policy has also been relatively loose in these countries, with real short-term interest rates negative in many of them, including, by some measures, China. Johanna Chua of Citigroup reckons that monetary conditions, including both interest rates and the exchange rate and, in China’s case, credit growth, have tightened already in Asia, but need to tighten further in both China and India.
• The reason for a rise in the oil price is as important as how large it is. An increase forced by higher demand is less dangerous than one driven by constricted supply, because it is evidence of a healthy global economy. If rapid growth means that China and India are importing more oil, they are probably importing larger amounts of other things as well, lessening the pain for slower-growing consumers of oil.
• Nonetheless, whether driven by demand or supply, a large enough spike in the price of oil can do great damage. Economists call such abrupt responses “non-linearities” and they suggest that when the price rises fast enough, consumers and businesses trim their spending and investment plans. This is often because prices are driven by other factors that hurt confidence, such as wide unrest in the Middle East. If another Arab government were toppled, pushing the oil price over $150, the economic impact would almost certainly be larger than the 0.5% to 1% of GDP that simple extrapolation suggests.
• James Hamilton, of the University of California, San Diego, has identified numerous periods since the late 19th century in America when an abrupt rise in the price of oil or petrol coincided with recession. Many of these were caused not by an interrupted supply, but by demand growth colliding with unresponsive supply. That seems to explain the price spike above $140 in mid-2008. Although the financial crisis was the main cause of the recent recession, Mr Hamilton argues that oil explains why the economy had already begun contracting before the worst of the crisis hit that autumn. Robert McNally, of Rapidan Group, a consultancy, concurs, arguing that American consumer confidence fell sharply once petrol went past $3 a gallon . It is now at $3.38, after the biggest one-week increase since Hurricane Katrina in 2005.
• Even if the unrest leaves supply unaffected, significantly higher prices may be only a matter of time. The same dynamic that drove the oil price skyward in 2008 is steadily reasserting itself. Supply is not growing substantially, and global demand, which regained its pre-recession peak last year, is expanding briskly again.

• Given enough time, the rich countries should be able to adjust to higher prices. Jim Burkhard of IHS Cera, a consultancy, notes that OECD oil demand peaked in 2005 and has been slipping since in response to the upward march of prices. In America a shift in consumer purchases towards more fuel-efficient vehicles, ethanol mandates and higher fuel-economy standards have all capped growth in petrol demand. Meanwhile, the higher world price has unlocked new supply within the United States, and elsewhere, which was previously too expensive to exploit.

• Yet it may take years for such trends to dent demand and boost supply by much; and the world may not have a lot of time. “Historians will look back on 2008 as the first time in modern memory that spare capacity ran out without a war in the Persian Gulf, and OPEC failed to cap prices,” says Mr McNally. “Eventually we’ll replay that scenario. If OPEC can’t control the market any more, that means prices will have to swing much more.”

diversified multinationals from emerging markets on the rise

• Over the past decade the world’s corporate pecking order has been disturbed by the arrival of a new breed of plucky multinationals from the emerging world. These companies have not only taken on Western incumbents, snapped up Western companies and launched exciting new products. They have challenged some of the West’s most cherished notions of how companies ought to organise themselves.
• Many emerging-market multinationals are focused companies that are admired in the West: the likes of India’s Infosys Technologies (for IT services), Brazil’s Embraer (aircraft) and South Africa’s MTN (mobile phones). But others are highly diversified. In some ways these groups look like throwbacks to old-fashioned Western conglomerates such as ITT. But in other ways they are sui generis: much more diversified and readier to blur the line between public and private.
• The most remarkable of these is India’s Tata group, active in everything from cars to chemicals and from hotels to steel; Tata is so big that several of its companies are important multinationals in their own right . But others are also global forces: they include Alfa from Mexico, Koc Holding from Turkey and the Votorantim Group of Brazil. And dozens more are trying to break free of their national moorings. Tarun Khanna, of the Harvard Business School, calculates that such organisations are the most common business form in emerging markets. In India about a third of companies belong to wider entities. In Hong Kong 15 families control more than two-thirds of the stockmarket.
• There are plenty of reasons to doubt the durability of these business groups. Many of them have thrived because they have close relations with their national governments. They are far too susceptible to scandal (witness the current furore in India over the sale of mobile-phone licences to favoured groups). Others are incapable of managing their diverse portfolios. Western stockmarkets habitually apply a discount to conglomerates’ shares.
• Yet there is more to these groups than cronyism. A growing number of them are proving that they can compete in global markets as well as in sometimes rigged local ones. The Boston Consulting Group lists the rise of diversified global conglomerates as one of five trends that will shape the future of business. Mr Khanna reckons firms that belong to India’s business groups frequently outperform free-standing companies.
• Such groups developed partly to deal with the problems of operating in places where governments are frequently incompetent and markets are hopelessly underdeveloped. Western management gurus love to advise companies to stick to their knitting. But in emerging markets your knitting may be your ability to stitch your way around underdeveloped markets rather than just your ability to manufacture a particular product. The key to Tata’s success arguably lies in its ability to recruit talented local staff (against stiff Western competition) and to assure quality across a wide range of products.
• The business groups are nimble decision-takers and have proved strikingly successful at seizing opportunities in other emerging markets. Koc’s food-retailing business, Migros, has expanded throughout the Balkans and the former Soviet Union. Carlos Slim has extended his telecoms empire across Latin America. Tata also suggests that there may be yet another advantage in diversification: the ability to develop skills across a wide range of businesses. Not only are various Tata companies trying to produce “frugal” products such as the Nano, an ultra-cheap car. They are pooling their resources: Tata Consultancy Services, Tata Chemicals and Titan Industries co-operated to produce the world’s cheapest water purifier.
• In the long run most of these emerging conglomerates are likely to follow the same path as Western companies: focusing on their core activities and buying ever more services from the market. But Western companies also need to recognise that—for the time being at least—these diversified giants have plenty to offer. Western firms may need to form joint ventures with “old-fashioned” conglomerates in order to win entry to fast-growing emerging markets. They may even find that they have to embrace diversification as they try to compete in these markets. The best emerging-market companies have learned a great deal from the West in recent years. It is time for Western multinationals to return the compliment.

without faster growth,the world’s rich economies will be stuck

• What will tomorrow’s historians see as the defining economic trend of the early 21st century? There are plenty of potential candidates, from the remaking of finance in the wake of the crash of 2008 to the explosion of sovereign debt. But the list will almost certainly be topped by the dramatic shift in global economic heft.
• Ten years ago rich countries dominated the world economy, contributing around two-thirds of global GDP after allowing for differences in purchasing power. Since then that share has fallen to just over half. In another decade it could be down to 40%. The bulk of global output will be produced in the emerging world.
• The pace of the shift testifies to these countries’ success. Thanks to globalisation and good policies, virtually all developing countries are catching up with their richer peers. In 2002-08 more than 85% of developing economies grew faster than America’s, compared with less than a third between 1960 and 2000, and virtually none in the century before that.
• This “rise of the rest” is a remarkable achievement, bringing with it unprecedented improvements in living standards for the majority of people on the planet. But there is another, less happy, explanation for the rapid shift in the global centre of economic gravity: the lack of growth in the big rich economies of America, western Europe and Japan. That will be the focus of this special report.
• The next few years could be defined as much by the stagnation of the West as by the emergence of the rest, for three main reasons. The first is the sheer scale of the recession of 2008-09 and the weakness of the subsequent recovery. For the advanced economies as a whole, the slump that followed the global financial crisis was by far the deepest since the 1930s. It has left an unprecedented degree of unemployed workers and underused factories in its wake. Although output stopped shrinking in most countries a year ago, the recovery is proving too weak to put that idle capacity back to work quickly (see chart 1). The OECD, the Paris-based organisation that tracks advanced economies, does not expect this “output gap” to close until 2015.
• The second reason to worry about stagnation has to do with slowing supply. The level of demand determines whether economies run above or below their “trend” rate of growth, but that trend rate itself depends on the supply of workers and their productivity. That productivity in turn depends on the rate of capital investment and the pace of innovation. Across the rich world the supply of workers is about to slow as the number of pensioners rises. In western Europe the change will be especially marked. Over the coming decade the region’s working-age population, which until now has been rising slowly, will shrink by some 0.3% a year. In Japan, where the pool of potential workers is already shrinking, the pace of decline will more than double, to around 0.7% a year. America’s demography is far more favourable, but the growth in its working-age population, at some 0.3% a year over the coming two decades, will be less than a third of the post-war average.
• With millions of workers unemployed, an impending slowdown in the labour supply might not seem much of a problem. But these demographic shifts set the boundaries for rich countries’ medium-term future, including their ability to service their public debt. Unless more immigrants are allowed in, or a larger proportion of the working-age population joins the labour force, or people retire later, or their productivity accelerates, the ageing population will translate into permanently slower potential growth.
• Faster productivity growth could help to mitigate the slowdown, but it does not seem to be forthcoming. Before the financial crisis hit, the trend in productivity growth was flat or slowing in many rich countries even as it soared in the emerging world. Growth in output per worker in America, which had risen sharply in the late 1990s thanks to increased output of information technology, and again in the early part of this decade as the gains from IT spread throughout the economy, began to flag after 2004. It revived during the recession as firms slashed their labour force, but that boost may not last. Japan’s productivity slumped after its bubble burst in the early 1990s. Western Europe’s, overall, has also weakened since the mid-1990s.
• The third reason to fret about the rich world’s stagnation is that the hangover from the financial crisis and the feebleness of the recovery could themselves dent economies’ potential. Long periods of high unemployment tend to reduce rather than augment the pool of potential workers. The unemployed lose their skills, and disillusioned workers drop out of the workforce. The shrinking of banks’ balance-sheets that follows a financial bust makes credit more costly and harder to come by.
• Optimists point to America’s experience over the past century as evidence that recessions, even severe ones, need not do lasting damage. After every downturn the economy eventually bounced back so that for the period as a whole America’s underlying growth rate per person remained remarkably stable (see chart 2). Despite a lack of demand, America’s underlying productivity grew faster in the 1930s than in any other decade of the 20th century. Today’s high unemployment may also be preparing the ground for more efficient processes.
• Most economists, however, reckon that rich economies’ capacity has already sustained some damage, especially in countries where much of the growth came from bubble industries like construction, as in Spain, and finance, as in Britain. The OECD now reckons that the fallout from the financial crisis will, on average, knock some 3% off rich countries’ potential output. Most of that decline has already occurred.
• The longer that demand remains weak, the greater the damage is likely to be. Japan’s experience over the past two decades is a cautionary example, especially to fast-ageing European economies. The country’s financial crash in the early 1990s contributed to a slump in productivity growth. Soon afterwards the working-age population began to shrink. A series of policy mistakes caused the hangover from the financial crisis to linger. The economy failed to recover and deflation set in. The result was a persistent combination of weak demand and slowing supply.
• To avoid Japan’s fate, rich countries need to foster growth in two ways, by supporting short-term demand and by boosting long-term supply. Unfortunately, today’s policymakers often see these two strategies as alternatives rather than complements. Many of the Keynesian economists who fret about the lack of private demand think that concerns about economies’ medium-term potential are beside the point at the moment. They include Paul Krugman, a Nobel laureate and commentator in the New York Times, and many of President Barack Obama’s economic team.
• European economists put more emphasis on boosting medium-term growth, favouring reforms such as making labour markets more flexible. They tend to reject further fiscal stimulus to prop up demand. Jean-Claude Trichet, the president of the European Central Bank, is a strong advocate of structural reforms in Europe. But he is also one of the most ardent champions of the idea that cutting budget deficits will itself boost growth. All this has led to a passionate but narrow debate about fiscal stimulus versus austerity.
• This special report will argue that both sides are blinkered. Governments should think more coherently about how to support demand and boost supply at the same time. The exact priorities will differ from country to country, but there are several common themes. First, the Keynesians are right to observe that, for the rich world as a whole, there is a danger of overdoing the short-term budget austerity. Excessive budget-cutting poses a risk to the recovery, not least because it cannot easily be offset by looser monetary policy. Improvements to the structure of taxation and spending matter as much as the short-term deficits.
• Second, there is an equally big risk of ignoring threats to economies’ potential growth and of missing the opportunity for growth-enhancing microeconomic reforms. Most rich-country governments have learned one important lesson from previous financial crises: they have cleaned up their banking sectors reasonably quickly. But more competition and deregulation deserve higher billing, especially in services, which in all rich countries are likely to be the source of most future employment and productivity growth.
• Instead, too many governments are determined to boost innovation by reinventing industrial policy. Making the jobless more employable should be higher on the list, especially in America, where record levels of long-term unemployment suggest that labour markets may not be as flexible as many people believe.
• Faster growth is not a silver bullet. It will not eliminate the need to trim back unrealistic promises to pensioners; no rich country can simply grow its way out of looming pension and health-care commitments. Nor will it stop the relentless shift of economic gravity to the emerging world. Since developing economies are more populous than rich ones, they will inevitably come to dominate the world economy. But whether that shift takes place against a background of prosperity or stagnation depends on the pace of growth in the rich countries. For the moment, worryingly, too many of them seem to be headed for stagnation.