The World Economic Forum (WEF) predicts that the next 12 months will see heightened levels of political and economic uncertainty not seen for the last 10 years.
In its annual report reviewing global risks it argues that US recession sparked off by the current liquidity crunch is possible and this will exposure vulnerabilities in the current model of financial markets.
Financial market risks
The report describes how the trend for diversifying risk through various new financial tools has been a positive development in the economically good times. However, in the current more turbulent times, "systematic financial risk” is becoming a greater concern.
It also raises questions over whether domestic-led growth in the Asian markets can continue drive the global economy as well as suggesting economic development in the central and eastern European economies might not be as sustainable as once thought.
The resilience of the export-led growth of other key European economies might also be tested if the credit turmoil spreads more widely through the financial markets.
There have been previous crises linked to systematic financial risk in past decades, for example the equity crash of October 1987 or the financial asset crisis of 1997.
However, contributors to the report, speaking at the WEF press conference in London, suggested that the current situation could not be directly compared to previous events given the number and complexity of new financial instruments now being used in the market to diversify risks.
Speaking at the conference, David Nadler, vice-chairman, of the CEO at Marsh and McLennan Companies described how over the last 20 years the financial markets have been radically changed, and will have their resilience tested over the forthcoming decades.
Major changes have included the continued deregulation of the markets, encouraging increased cross-border activity. There has also been heightened financial innovation with more derivative and structured products entering the market.
These products arguably allow for the more efficient distribution of risk but it also raises issues of assessing who ultimately carries that risk. Even with the introduction of Basel II, there are concerns remaining that regulation is not developing as fast as market innovation.
Other key developments in the financial markets include the rise of alternative capital pools such as sovereign wealth funds and the changing role of non-bank institutions. There is also increased convergence between financial institutions, where banks are supplying capital for insurance risks and both banks and reinsurers are making use of insurance-linked securities.
Due to these trends, the WEF highlights another key trend for 2008 as the decentralisation of risk ownership, meaning that future crises will tend to emerge in particular markets, rather than just within the institutions themselves, given that risks have been so widely spread.
Food security risks
The price of basic foodstuffs has also been noted as a key emerging risk for the next year and subsequent decades. The price of corn was 50% higher at the end of 2007 compared to the previous year, and global food reserves are at their lowest for 25 years.
Speaking at the press conference, Christian Mumenthaler, head of life and health products, member of the executive board at Swiss Re spoke of the "green revolution” and the introduction of improved agricultural technology in the mid-20th century which helped ensure that the existing farmland could be used more efficiently to meet the needs of a growing population.
However, given the growth of developing nations and their increasing demand for a more protein-based diet, Mumenthaler raises the question of whether the current levels and methods of food production are sustainable.
This is particularly relevant given the fact that global populations will continue to grow and that the expanding biofuel industry will require crops as feedstock, which could potentially divert produce from being used as food.
Supply chain risks
WEF also highlighted some of the negative aspects and potential risks of the increasing level of global trade.
Over the past 20 years, improvements in technology and global logistics as well as reduced trade barriers have led to more efficient supply chains and increased volume of trade.
However the complexity of the new supply chains has increased companies vulnerability to a wider range of risks, and according to WEF these “vulnerabilities to the supply chain are generally poorly understood and managed”.
There has also been increased geographic concentration of risk, whereby an event happening in one particular region can have a knock-on effect throughout the supply chain.
The report gives the example of the earthquake in Taiwan in 1999 which resulted in the doubling of the price of semiconductors. US and European companies sourcing from Asia are now indirectly facing risks they would never have dealt with domestically.
Global energy requirements are also throwing up a number of interconnected risks, according the WEF. Its predictions for 2008 see no potential fall in energy prices over the next decade.
Speaking at the press conference, David Nadler comments that, “the global economy has demonstrated remarkable resilience to increases in energy prices.” However, the limits of the world's economies may be about to be reached.
There are also two conflicting objectives within the energy sector; that of securing reasonably priced fuel and that of reducing greenhouse emissions.
WEF provides some examples of how this conflict of interests manifests itself, for instance in Europe and US investment in the power sector is being limited due to uncertainty over future regulations of green house emissions.
However, if adequate investment is not made in power plants there is increased likelihood of future shortages of power and increased electrical power costs. Some of the solutions to better managing risk outlined in the report include establishing country risk officers to improve risk management at a national level.
Innovation in the financial markets is also seen as another means of mitigating risks, particularly through the emergence of a new market in insurance-linked securities (ILS), which can provide additional capital to the insurance industry to protect against major catastrophe losses. The ILS market has seen significant growth in recent years with total bonds outstanding reaching a total of US$34bn. Other financial instruments being developed include weather derivatives, which are being used to transfer insurance risks. These instruments can provide rapid payments to governments and farmers who can use them to hedge against weather-related risks such as too little rainfall or drought in the growing season.
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