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The red herrings

By Ian Bremmer and David Gordon

Now for the red herrings, the places and problems where we think there is less risk than meets the eye.

In Iraq, elections in March will spark violence as foreign militants try to undermine the transition to Iraqi national sovereignty. A U.S. troop withdrawal beginning right after the elections will invite more violence. We could see a Sunni election boycott. But compared to what we've seen before, and what might have happened, the overall story is remarkably positive. For the markets, Iraq is suddenly an opportunity. The institutions are becoming legitimate (even with the unresolved Kurdish issue), the army is starting to work, and most importantly, political leaders from all communities are beginning to recognize the value of Iraq's tremendous natural resource base from which all can benefit if they make the compromises to maintain stability in the country. For all their basic governance problems, there's very little chance of Iraq actually becoming a failed state at this point -- a meaningful risk even a year ago. It's not a place we're ready to vacation in, but we're bullish on Iraq.

Iraq is also moving in a positive geopolitical direction. Ties with Turkey have grown particularly quickly -- not just in the Kurdish region in the north, but in Baghdad. That's one of the few positive stories for Ankara this year. Arab states in the region are still hesitant to build ties with Iraq as they wait for clarity on its next government. Maliki hasn't been a popular figure with neighboring gulf Arabs, but they recognize that Iraq's economic consolidation won't wait for another four years, and they'll start making political overtures to Baghdad if Maliki's mandate is extended. And if the Iraqi prime minister isn't returned (which is certainly plausible), we'll see a stream of head of state visits to place relations with a new leader on a more solid footing. So whatever the electoral outcome in March, we're likely to see Iraq on a faster path to integration with regional political and economic infrastructure next year. Meanwhile, Iran's role in Iraq has quietly receded. Iran's controversial presidential election and subsequent state violence did nothing to improve Tehran's influence among Iraq's Shia population, where Iraqi nationalism has been steadily growing.

The headlines for Iraq next year will undoubtedly be the timing/delays/pace of the US troop withdrawal. But the real story is going to be a moderate government, growing geopolitical influence, and the most exciting new investment opportunities the region has seen in a decade.

Iraq's gain trumps Dubai's loss in the Persian Gulf, and the rest of the region is doing just fine. There is strong political stability, increasingly coherent policy approaches, and lots of reasons for broader, more sensible investment trends diversifying away from over-reliance on oil.

The outlook is particularly promising for Saudi Arabia, where there's strong reason to believe that political succession will ultimately be handled well. And they're slowly but surely unlocking the economic potential of larger and larger pieces of their country -- geographically, sectorally, and most important, demographically. Neighboring (and far more socially liberal) Bahrain will also benefit significantly from that trend. Abu Dhabi is taking over more coordinated direction of economic (and regional political) policy for the United Arab Emirates, a far more sensible model for national development. Smaller countries like Oman and Qatar have the economic and political stability to benefit from the region's rise.

This year, Russia gets through the downturn and starts to look stable again. Prime Minister Vladimir Putin will feel more confident, and anybody who doesn't agree with him can leave or face the consequences. The country doesn't really deserve to be a BRIC, because its longer-term trajectory is more ominous (with a tough geopolitical neighborhood, a precipitously declining population, and negative trends in governance). But for this year, especially with energy prices having doubled off their lows, Russia will go back to being uninteresting.

Then there's the dollar. The United States will continue to run a massive deficit with crisis reduced tax revenues, high levels of spending and few near-term moves to raise revenue in the cards for 2010. And while the Obama administration has big plans for fiscal responsibility, much of it is hard to get through Congress, while other pieces of the plan are typical/political accounting sleight of hand. With the Chinese saying the world needs a new reserve currency and the Indians buying gold, does anyone believe in the dollar any more?

Well, yes. But it's important to start with recognition that the dollar's relative value and reserve currency status are related, but separable. A weaker dollar can still be the primary reserve currency -- that's been a long running story over the past six decades.

The status of the dollar as the world's reserve currency is much stronger than the hyped commentary. To paraphrase Churchill, the dollar's outlook is the worst of the developed currencies out there ... except for all the others. For now, if there's dollar weakness, it's at least in part that the United States wants a weak dollar to boost exports (since domestic consumption is going to stay weak for a while). Longer term, U.S. demographic growth, the pull from higher education, a strong penchant for innovation, a continuing military lead (which will increasingly matter for commodities), underlying political stability and sheer size will keep the dollar going as the world's preeminent reserve currency. 

That's not to say there's no structural weakness. Over time, should China manage its challenges successfully, the yuan will rise in both value and utilization. But for the foreseeable future, even if the dollar's relative value falls, its reserve currency role is not going anywhere in the next decade and probably well beyond. Similarly...

All this fear about "finance" running away from New York and London -- because of regulatory burdens or growth outside the developed world -- is misplaced. Bankers like to complain about regulations and to threaten to move elsewhere. It's far harder to execute. The slow pace of change is particularly true for the physical location of the top financial markets, and the fact that Singapore does more bond issuances in one particular year than does London doesn't mean it will overtake the city anytime soon. Since the year 1600, there have been three top financial centers: Amsterdam, London and NYC (well, Paris too, which made a run at it in the 18th-19th centuries). Rapid and massive shifts in the way money is intermediated are unrealistic.

Capital can be generated anywhere (Chinese factories, Middle East oil, etc), but capital intermediation (most finance) needs a set of special political, economic and social conditions in which to thrive. Structurally, successful capitals of finance require stable legal systems, stable political systems, effective/apolitical policing of corruption, low levels of social unrest and violent conflict, large and highly literate work forces, a large economic base to sustain financial activities, and a liberal policy orientation that welcomes cross-border flows of people, goods, and capital. Except for the United States and the EU/Switzerland, only Tokyo meets all these requirements. But Japan has elements of a closed economy, lacking as much of an international orientation, as reflected in a relatively low level of English proficiency.

If the United Kingdom truly cracks down on its financial industry (a possibility), some of it will disperse ... with New York standing to gain the most. If the United States decides to impose tough regulations while Europe doesn't (much less likely), we'll see more dispersion, with smaller jurisdictions picking up some of the more risky/profitable activities (hedge funds). But for the most part, large financial institutions will stay put, grumble, and try to reverse whatever regulations the United States and the United Kingdom burden them with.

Ian Bremmer is president of Eurasia Group, and David Gordon is the firm's head of research.

 

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