The Taiwan Banker

The Israel-Hamas conflict that broke out at the beginning of the year, the recent Red Sea crisis, the U.S.-China trade war starting in 2018, and the 2022 Ukraine war all demonstrate the impact of geopolitical risk on recent politics and economics. These conflicts have significantly weakened the accuracy of major economic forecasts. In October 2020, for example, the International Monetary Fund’s (IMF) forecast global 2024 GDP growth at 3.63%. The forecast was changed to 3.37% one year later, and then again to 3.18%. In October 2023, it was again adjusted to 2.94%, a continuous downward trend, due in part to the Ukraine war. Similarly, the IMF has decreased China's estimated 2024 GDP growth rate several times, from 5.65% down to 4.16%. Several forecast periods were hampered by the pandemic and the lockdown in Shanghai, but the impact of geopolitical events such as the trade war and Ukraine war cannot be ignored. Risks affect the economy Why do geopolitical risks impact the accuracy of forecasts? Most textbooks on forecasting or economic methods focus on the technical aspects, rarely mentioning political, let alone geopolitical risks. Even the 2019 Forecasting: An Essential Introduction, by Castle et al., mentioned that black swan events (Box 1) may cause prediction errors; yet the book still focuses on technical terms, such as probability density forecasts, location shifts, and loss functions, without exploring the links to political risk. So what exactly is geopolitical risk? Bremmer and Keat write that any political event which directly or indirectly alters the value of economic assets can be regarded as a political risk, including war, terrorism, legislative expropriation of private property, and legal changes, or foreign investment regulations. Caldara and Iacoviello write that geopolitical risk is the threat or actual occurrence of negative events involving war or terrorism, or tensions between countries or politicians, affecting peaceful development or international relations. Many geopolitical events in history have displaced international financial centers. In the mid-1700s, following wars in Europe, the Netherlands lost its dominant position, causing the international financial center to move to London. When Britain focused its funds on WW1, it transformed from the world’s largest overseas investor and creditor to largest debtor, and international investors began to look for other safe places for funds. New York became the first choice, and still ranks first among international financial centers to this day. Forecasts should account for geopolitics Statistics tend to neglect political risks, because the numbers only account for a normal world. Since the end of World War II, most of the world has been at peace, so statistics tend to underestimate conflict due to statistical scarcity. In real life, the probability of extreme values ​​(fat tails) with material impact is much more likely. Bremer and Kitt categorized risks into three scenarios through based on the probability of occurrence and severity of impact: insignificant, major, and catastrophic. The first two can usually be calculated through standard statistics, but special methods are needed to deal with the third; most catastrophic risks are volatile and difficult to predict. Whether it is called fat-tail risk or catastrophic risk, the top priority when incorporating geopolitical risk into overall economic forecasts is to build rigorous quantitative indicators. The geopolitical risk (GPR) index based on news, including daily, monthly, global and country indices, and with data from 1900 onwards, published by Caldara and Ecovero in the famous economics journal “American Economic Review” in 2022, has great reference value. A higher GPR index predicts economic disaster, and reduced investment and employment; regarding micro-level corporate data, industries with higher GPR exposure are negatively impacted. The impact is large, resulting in reduced investment. The GPR index mainly draws on news reported by important media from the United States, Britain, and Canada, but referring to major geopolitical events since the 20th century, the reliability of the index is quite high. The historic relative peaks of the global GPR index index mostly occurred shortly after the outbreak of wars and conflicts (Fig. 1); the same was true for the Ukraine war in February 2022 and the Israel-Hamas conflict in October 2023. Therefore, this index is quite reliabile, even for short-term events. Since Taiwan also falls within the scope of the index, examining its past long-term and short-term geopolitics, we also find that its reliability is high (Fig. 2). The GPR index surged upon the retreat from Dachen Island in February 1955, the artillery battle at Kinmen in August 1958, the missile crisis in March 1996, the first direct presidential election of the Republic of China, the Ukraine-Russia war in 2022, and the visit of U.S. House Speaker Pelosi to Taiwan. The U.S.-China question General forecasting models often incorporate simple dummy variables or more sophisticated Markov switching models to capture the dynamic behavior of variables in different states. However, when political conditions change frequently, certain dynamic behavioral characteristics may not be fully captured, inhibiting subsequent interpretation. The advantage of the GPR index is its use of numerical data, with no need to set up additional dummy or state variables. The index can be directly put into relevant structural equations. It is no longer just once in a century that geopolitics interferes with economics. Forecasters should use the GPR index to ensure their frameworks are useful. Frictions between the U.S. and China are one of the most high-profile geopolitical risks in recent times. It is not yet clear whether the two countries will fall into a Thucydides’s Trap. Judging from Bremer and Keat’s taxonomy, the rivalry is a slowly progressing in three stages: a “great power shift,” “economic sanctions and ambargoes” with a heightened sense of crisis among existing powers, and “international wars” with an overall increase in conflicts. The competition has clearly entered the second stage. As professor Jin at the London School of Economics and Political Science said, businesses and consumers are both key players in the Western free market economy. Although the government participates through fiscal policy, monetary policy, and a well-established financial market, its dominance is restrained. In contrast, China’s economic structure has two ever-present forces: industrial policy and state-owned enterprises (SOEs). The central government formulates strategies and local governments are responsible for their execution. Although China has incorporated the concept of the market economy, it eventually evolved into a “mayor and market” economy, rather than a true free market. Economic performance hinges on natural market fluctuations and loose legal interpretations. Economics and technology: the front lines of the new Cold War Although growth has slowed significantly since Xi Jinping’s ideas took root, the last 40 years have seen rapid development, including major accumulation of total factor productivity (TFP). For example, GDP increased from 6% of the U.S. in 1982 to 71% in 2022. During the pandemic, strict containment measures created bottlenecks in global supply chains, which also drew attention to China’s dominant market share in global production. In addition, more Chinese exchange students are returning to China, global rankings of Chinese universities have improved, the number of patent applications is higher than many competing nations, and military expenditures have also increased sharply. Historically, when a global hegemon begins to feel pressure from a developing nation, it tends to intiate economic sanctions. If the opposing party holds favorable bargaining chips, it will apply counter-sanctions in response. Most sanctions since World War I have been ineffective in quelling conflict – for example, after the U.S. imposed an embargo on Japanese oil from 1939 to 1941, Japan attacked Pearl Harbor, eventually setting off a conflict in the Pacific. After 1979, the U.S. imposed extensive trade, energy, military, and financial sanctions on Iran in response to its nuclear program. However, Iran has so far not changed its plans to expand regional influence and develop large ballistic missiles and armed drones. In 2018, U.S. President Trump accused China of stealing U.S. intellectual property and commercial secrets, and launched a trade war against China. After President Biden came to power, aiming to slow down China’s development in major emerging technologies such as semiconductors and AI, he further escalated the trade war into a technology war. As a result, China strengthened its own production ability, and it has also countered by restricting the export of some products (such as rare earths). Regarding whether frictions between the U.S. and China could turn into an international war, New York University professor Roubini mentioned in his 2022 book Megathreats that the new Cold War is indeed one of the factors with the greatest impact on the current political and economic order. At the turn of the millennium, the U.S. and China maintained a friendly relationship. China had just joined the World Trade Organization (WTO), and the U.S. wanted China to integrate with the international economy. Following the 2008 financial crisis, however, China began to believe that its economic model was superior to poorly regulated market economies and dysfunctional democracies. As Xi came to power in 2013, he successively launched development strategies such as the Belt and Road Initiative and Made in China 2025, allowing China to take the lead in emerging technologies such as 5G, while gaving rise to increased competition with between the U.S. Compared with after 2000, China has increasingly focused on domestic and international development, and its efforts have increased their soft power. In comparison, the U.S. spent a great deal on military support for the Middle East, achieving very little. Thus, the U.S. lost its national power and international prestige (Figure 3), which has made it keenly aware of China’s rise. As Kevin Rudd said, “The current U.S.-China relationship may not yet be Cold War 2.0, but it has begun to resemble Cold War 1.5.” It is worth noting that after Xi Jinping’s meeting in San Francisco in mid-November 2023, relations seemed to show signs of thawing again. The questiong going forward is whether China will abide by the commitments made during the meeting: preventing the flow of illegal fentanyl into the U.S., and reducing the number of fighter aircraft flying across the centerline of the Taiwan Strait. The Chinese economy trends downward Regarding China’s influence on the global economy, the question going forward is whether the current real estate debt problems and other internal economic risks, as well as continued tightening of sanctions by the U.S., will make it difficult for the Chinese economy to prosper. Pessimists point out that China’s economy faces four structural problems: it has passed its growth peak, Japanization, the population dividend has turned into a deficit, and politics has overtaken the economy. Optimists believe that the current problems may just be inevitable growing pains. Outside of these two extremes, Financial Times columnist Martin Wolf states, “China’s economy may not have passed its peak, there is still a solution to Japaneization, the population decline is a problem, and it is definitely a flaw for politics to override economics.” Especially after 2017, Xi’s primarily objective in ending the laissez-faire policies of the past was political and economic stability, rather than growth. At the same time, the his actions such as rectification of the high-tech industry and decoupling with the U.S. (starting with the trade war in 2018) have deterred Western investors. Speculators foresee many consequences for the economy – certainly, dynamism is fading. The biggest key to China’s economic future lies in politics: domestically, whether Xi convince the Chinese people that “common prosperity” is not just an ideal, but also a way to coexist and prosper while creating a more balanced economy; and internationally, how Beijing handles increasing competition with the U.S. and dispels doubts in the international community about its economic expansion are the most significant issues. In the face of geopolitical risk, forecasters should incorporate geopolitical risk indicators into economic forecasting models. Incorporating these risks will ensure that forecasts have a certain warning function for all sectors of society, thereby reducing the impact of geopolitical risk on the economy. The author of this article is an honorary professor at the College of Technology Management, National Tsinghua University Black swans vs. geopolitical events When speaking about geopolitical events, they are often viewed as black swan events, but it is important to differentiate the two. A black swan is extremely rare, but has an extreme impact that is disproportionate to the low probability of occurrence. Its two major characteristics are the impossibility in predicting the time of occurrence and degree of impact. For geopolitical risks, however, the probability of occurrence can still be dynamically predicted. Therefore, unlike black swan events, geopolitical risks are usually tractable. We should not dismiss all geopolitical events as black swans. Pearl Harbor 1941 · A few months before the incident, the U.S. military intercepted Tokyo demanding that Japanese spies at Pearl Harbor carefully and regularly report the number of warships docked in port. · The month of the incident, the Hawaii combat intelligence unit discovered that the Japanese military had twice changed the radio communication frequency that had been adjusted only once in the past six months. · A few days before the attack, the intelligence agencies of many countries intercepted Japan's instructions asking the local embassy to destroy its secret codes. · The afternoon before the attack, the director of the Hawaii intelligence unit sent a telegram related to the incident to senior officials, but it was ignored. In hindsight, the US military command system should have anticipated that Pearl Harbor would be attacked beforehand and responded accordingly. 9/11 · In 1996, Al Qaeda leader Osama bin Laden issued his first fatwa calling on American soldiers to leave Saudi Arabia. · In 1998, bin Laden issued a second fatwa outlining his opposition to U.S. policy toward Israel and the continued presence of troops in Saudi Arabia following the Persian Gulf War. Using Islamic proverbs, he called upon Muslims to attack Americans until their grievances were addressed. Judging from his anti-American remarks and actions since 1996, it was to be expected that radical organizations in the Middle East were waiting for opportunities to attack the U.S.