Apr 7, 2007

Stratfor's 2007 Second Quarter Forecast

Here is Stratfor's 2007 second quarter forecast for South Asia, East Asia and the Global Economy.

South Asia: Domestic Issues, the Taliban and Musharraf's Struggle

The annual forecast for 2007 emphasized that Pakistani politics would be the most significant driver in South Asia, as Pakistani President Gen. Pervez Musharraf's political standing would carry implications for the U.S.-led campaign against al Qaeda and Taliban forces in the region. This issue will remain dominant in the region in the second quarter.

Musharraf has devised a complex strategy to ensure that he remains in power as president and military chief through the January 2008 general elections. But his election gambit took a turn for the worse in March when he acted on bad advice and gave the green light to sack the country's chief justice. Though Musharraf's intent was to clear a potential obstacle to his re-election bid, he sparked a nationwide outcry against the military-dominated regime that has forced him into a compromising situation that will end up forcing him to give up a certain degree of power.

Musharraf will be in damage-control mode during the second quarter, and could attempt to temporarily defuse the crisis by restoring the chief justice. Such an outcome, however, will only further erode Musharraf's ability to rule, and would create a crisis of governance.

Meanwhile, radical Islamist forces in the country will take advantage of the political fracas to increase suicide attacks and expand their efforts to "Talibanize" Pakistan beyond the Pashtun areas. Given Musharraf's weak political standing, the Pakistani government's cautious approach will not thwart the growing radical movement. To salvage his political position and help combat religious extremism in the country, Musharraf might have no choice but to encourage his allies in the ruling Pakistan Muslim League to consider working out a power-sharing agreement with secular parties in the opposition, namely the Pakistan People's Party-Parliamentarians.

The United States will watch these developments in Pakistan closely, and will give Musharraf some breathing room while he attempts to sort out problems at home. Washington has an interest in ensuring that Musharraf maintains a hold on power and that the military remains at the helm, even if concessions need to be made to the civilian opposition parties.

Taliban activity in Afghanistan will intensify this spring, with a heavy emphasis on suicide attacks against Afghan and NATO forces. A coordinated campaign by Taliban and al Qaeda militants also appears to be under way, in which motorcades carrying high-value military or intelligence officials are singled out. NATO and Afghan forces will mount a strong counteroffensive, making this quarter a particularly bloody one.

The Afghan government of President Hamid Karzai and its NATO allies will focus on their hunt for pragmatic Taliban in an effort to undercut the jihadist insurgency. This will involve negotiating via tribal elders across the Pashtun areas in southern and eastern Afghanistan, reaching out to Hizb-i-Islami chief Gulbuddin Hekmatyar and driving a wedge between Taliban commanders in Afghanistan and the Taliban elements allied to the Mullah Omar-based leadership, which has close links to al Qaeda and the Pakistani Taliban.

In India, domestic political and social issues continue to absorb the government's attention. The ruling Congress party is struggling to maintain a populist attitude toward India's lower classes while appeasing Indian corporate interests. This balancing act has left both sides unsatisfied and has provided the main opposition Bharatiya Janata Party an opening to advance itself. Congress' hold on the central government will not be seriously threatened in the second quarter, but the party will have to rely heavily on populist measures to win back support.

A hot issue over the next few months will center on the creation of additional special economic zones (SEZs) throughout India. Impoverished farmers backed by vociferous leftist groups will intensify their resistance to the SEZs' creation. Maoist rebels, also known as Naxalites, will try to take advantage of the tensions stemming from the government's bid to acquire farmers' lands for the SEZs by intensifying their operations against security, political and economic targets in the states of Andhra Pradesh, Bihar, Chhattisgarh, Jharkhand and Orissa.

India also will pay closer attention to its southern neighbor, where the Sri Lankan army is engaged in major tit-for-tat fighting against the Liberation Tigers of Tamil Eelam. Colombo will lobby hard for increased military assistance and advanced radar equipment to combat the Tigers, but the Congress party will remain cautious about enhancing Sri Lanka's military capabilities for fear of alienating the Indian Tamil population and the party's Tamil political allies. The Tigers will attempt to resist Sri Lanka's aerial assaults in their eastern strongholds by turning to more spectacular attacks, including suicide bombings, and by demonstrating the expansion of their naval and air branches.

In Nepal, the interim government and Maoists will limp toward finalizing a peace deal that will allow the Maoists to formally enter the government and erode the royal family's political position. Though general elections are slated for mid-June, there is a strong possibility that they will not take place on time considering the deteriorating law and order situation in the southern plains of Terai, where Maoists and a group of plains people, known as Madhesis, are locked in turmoil.

East Asia: Continuing to Look Inward

Stratfor's annual forecast noted that 2007 would be a year for East Asia to look inward, focusing on domestic and regional issues -- with the regional rivalry between China and Japan growing prominent as the year played out. In the first quarter, this trend manifested itself in several ways.

The region's central governments continued to grow more powerful, especially in China, where Beijing tightened control over regional and local governments. The latest Communist Party secretary appointments undoubtedly strengthened Chinese President Hu Jintao's hold over the provincial and city leadership while consolidating Beijing's economic rule. Thailand's military regime also started planning to permanently reinsert itself into the country's political landscape. Regional geopolitical insecurity drove Beijing to undertake its January anti-satellite missile test, which was intended to warn the United States that although China said it would not "undertake military adventures in 2007," it also would not sit idly by should Taiwan attempt to push for formal independence on the eve of the 2008 Olympics.

Mirroring China, Taiwanese President Chen Shui-bian continued to push for independence in an effort to prevent Taiwan from becoming irrelevant within the region. Unexpected financial turbulence shook global markets when the Shanghai stock market dipped in March, sending ripples around the world. Fundamentals changed little afterward, however, as the ripples did not stem from any real change in China's economic structure; psychologically, though, China's capacity for global financial effects is in a new spotlight.

Domestic political consolidation and constitutional change are still the key domestic policy drivers in Japan and South Korea. Japanese Prime Minister Shinzo Abe is continuing to push for change for Japan's Constitution and defense structure, such as elevating the Defense Agency to a ministry and expanding defense cooperation with Australia. South Korea's ruling minority Uri Party split from President Roh Moo Hyun to clean house and select its presidential candidate, freeing up Roh to push through changes to the country's fundamentally diseased constitutional structure.

As we head into the second quarter, two dominant themes will drive events in East Asia: countries' introspection as they are consumed by internal elections and politicking, and intraregional nuclear discussions and economic interactions. Other possible factors are the emergence of a new trilateral Japanese-Australian-U.S. security arrangement and success for Taiwan's Chen in his efforts to provoke China. Probabilities for the former are nearly certain, and those for the latter are unknown.

Thailand is due for a new draft constitution April 19, which likely will enshrine the military's role in government, though not by including a clause for an "unelected prime minister" as previously suggested by the military chief. This will more likely happen via more subtle clauses designed to insert military representation throughout the central and provincial government departments. If the opposition uses this draft to generate a massive groundswell of anti-military sentiment, the regime's ability to retain control with minimal violence will be tested. The regime will continue to enhance its skills in balancing the country's different factions. The usual cycle of violence in the south will continue.

This quarter will see more Chinese political reshuffling to smooth the path for the country's fifth generation of leaders -- a process to be completed by 2012. Hu will move more of his chosen successors into place for final training before promotion to the Politburo, which likely will occur at the Party Congress this fall. Shanghai will be used as a new training ground for Hu protege Xi Jinping -- who recently was promoted to become the city's party secretary -- and also as a regional showcase of what local governments must do to avoid a crackdown. More responsibility for economic reforms will be shifted to private and foreign investors, with industries previously considered "too strategic" (such as oil and health care) being released from the state's iron grip. The new foreign exchange investment company could be established this quarter in order to kickstart an outward flow of renminbi-denominated investment funds. China needs to continue pushing investors to send their appreciating local currencies overseas in order to rein in an excess supply of money inside the country -- a root cause of the economy's imbalanced growth.

The first stage of the six-party nuclear deal is set for completion April 14, when North Korea closes its Yongbyon reactor. Each party will use minor reasons to delay progress in order to pursue its own agenda, but progress should still continue, with or without directly addressing North Korea's existing nuclear weapons.

This quarter kicked off with a successful conclusion to the South Korean-U.S. free trade agreement (FTA) talks. A flurry of intraregional interactions now will descend upon East Asia, with South Korea likely to speed up efforts to make similar agreements with the European Union, Gulf Cooperation Council states and China. Another deal worth watching is the Australian-Japanese FTA talks starting April 23, which could shed more light on the new regional trilateral security arrangement. For the rest of East Asia, FTAs and economics will be the main channel through which bargaining chips are dealt and exchanged in return for progression on other economic and political issues. Talk of a regional FTA might even resurface.

The structure of East Asia's new trilateral security arrangement will emerge, as the lines of military cooperation and interdependencies between Japan, Australia and the United States gradually take shape. China and Japan will continue a flow of positive diplomatic rhetoric and superficial actions, but remain fundamentally distrustful of each other. China will try to use its economic leverage with Australia to influence or gain additional insights into the new arrangement being established in its backyard. While still preoccupied in the Middle East, the United States will not explicitly target China, but the new security arrangement is intended to indicate where Washington's attention will next settle.

Taiwan's Chen already has swapped out his country's representative to the United States and convinced the Democratic Progressive Party to propose the formal abandonment of the "Five Nos" policy. Although he is constrained in his push for constitutional change, Chen's ultimate goal is to reshape both the domestic and international perceptions of Taiwan. With Beijing preparing to host the 2008 Olympics, Chen sees this as his opportunity to rile China with his "provocative" comments and acts. Either he will prod China into lashing out -- thus proving his point that China is the real threat to regional security -- or China will simply ignore Chen's actions, giving him proof for the Taiwanese people that Beijing's threats are hollow and that Taiwan should formally pursue its own national identity and independence. Either way, Taiwan will become a key driver of regional security attention and arrangements.

Global Economy: Short-Term Shakiness, But No Recession

Stratfor expects that the irrationalities introduced by the past six years of rapid economic growth could trigger a shakedown in the U.S. economy that will stop shy of an actual recession. By the end of the second quarter, however, the United States will have dodged the bullet and should be surging ahead. The quarter could even end with the rest of the world wobbling as the United States climbs, but this too likely will pass.

Unfortunately for the rest of the world, the United States does not exist in isolation. From 1945 to 1985, very little of the U.S. economy was locked up in international trade, so when the United States suffered a recession, that recession's effect on the rest of the world was rather limited. As time rolled on, however -- and certainly by the late 1990s -- the United States became more involved, and now trade is just over 25 percent of the country's gross domestic product (GDP). In relative terms, that is still rather little (Germany's trade is more than 70 percent of its GDP), but in absolute terms it represents about $3 trillion annually.

In practical terms, the U.S. economy has become the global economy's market of first and last resort. Consequently, to paraphrase Wall Street investors, when the United States sneezes, the world catches a cold. Before the United States became so exposed, a U.S. recession meant money fled abroad. Now, however, since much of the rest of the world depends on U.S. markets, economic troubles in the United States directly translate into economic problems in the countries that like to sell to the United States.

So U.S. economic troubles still lead to capital flight, but now that flight is to the United States instead of from it. One result of this is that recessions are extremely short and mild in the United States. (Witness the brief, shallow recessions of 1990-1991 and 2001 -- the only recessions the United States has suffered in the past 25 years.) The one saving grace for the rest of the world -- and it is a huge one -- is that, compared to what it was in 1990, domestic consumption in the developing world (including China) and in Europe has expanded greatly.

While the United States certainly is the system's center, the rest of the system has sufficient bulk to self-ballast. So though a U.S. slowdown still causes more problems overseas than it does in the United States, it is hardly tantamount to an economic death sentence.

Overall, the economic volatility of the first quarter will intensify in the second, but by the time we reach the third, the United States will have pulled through. Once that happens, confidence should leak back into the rest of the global system and short-circuit a similar slowdown before it can do any serious damage.

However, there are two outliers to note.

First, U.S. economists are concerned about faltering subprime mortgage markets. To make an incredibly complex story simple, subprime mortgages are granted to people whose credit is not strong enough to qualify for a mortgage under normal circumstances. The specific part of the market that is suffering are those subprime lenders who have taken on variable-rate mortgages, which lock in an extraordinarily low rate -- allowing almost anyone to qualify because of the low payments that result -- but then force a later refinancing at normal rates, typically five years hence. These subprime variable-rate mortgages were first offered en masse five years ago. Now it is time to pay the piper, and many cannot. The good news is that of a total U.S. mortgage market of $10 trillion, the entire subprime market -- and many of these will not go bad -- is "only" worth about $650 billion. The bad news is that this sort of irresponsible mortgage has been given out for five years now, which means more mortgages are guaranteed to go bad. The impact is small, but the tailwind is now locked into the system for the next five years.

Second, there are two states where additional economic problems could crop up in the second quarter. The first, Japan, is the only country where domestic demand continues to underperform, making it perennially vulnerable to international economic downdrafts. Fresh statistics also indicate that deflation -- once thought defeated -- has returned. The second state, Germany, is struggling to slough off a decade of subpar growth. To balance its budget, Germany raised its consumption tax by 3 percent in the first quarter -- a step that, while fiscally sound, risks the recent progress Germany has made resuscitating its economy.

Of the two, we are more hopeful for Germany, where growth -- and confidence -- is better entrenched.[Stratfor]

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