Coronavirus, green swans and unknown unknowns

Donald Rumsfeld, the controversial Defence Secretary during the administration of George W. Bush, coined the phrase “unknown unknowns” in 2002 to describe uncertainties associated with Iraq’s weapons programs.

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Rumsfeld was parrying reporters’ questions about exactly what the administration knew about Iraq’s weapons of mass destruction (WMD) as a pretext for going to war.

“By any measure the coronavirus crisis was an unknown unknown in the sense that no-one predicted 2020 would dawn in the shadow of a potential health pandemic.”

As it turned out, Iraq did not have an unknown unknown WMD program.

The Rumsfeld quote has been used ever since as a parody for what officials say about unforeseen events that defy reasonable explanation - or any explanation at all.

Health emergency

In the early months of 2020 the world has been hit hard by an unknown unknown in the form of what appears to be an animal-born virus said to have originated in a live animal market in Wuhan, the capital of Hubei province in central China.

Researchers have isolated the coronavirus, as it’s called, but they remain unsure about the host of this flu-like threat to the health and well-being of not simply China itself but the international community and, by extension, the global economy.

By any measure the coronavirus crisis was an unknown unknown in the sense that no-one predicted 2020 would dawn in the shadow of a potential health pandemic or that a fragile global economy would be subject to a shock caused by a health emergency.

We might add the virus is now a known unknown – we know a lot about it but still don’t know how it will play out.

The coronavirus outbreak, in which hundreds of people have died and thousands more infected in China, is shaping as the most serious threat to global economic growth since the Global Financial Crisis (GFC).

As well as an unknown unknown it is a “black swan” event - a phrase coined by the futurologist Nassim Nicholas Taleb to describe a shock that has materialised seemingly out of nowhere.

Fire sale

Coincidentally, and completely unrelated to any black swan unknown unknown event such as the coronavirus crisis, the Bank of International Settlements (BIS) issued a paper warning of a potential “green swan” event.

The BIS outlined alarming scenarios in which fossil fuels could become “stranded assets” unwanted by investors in an environment in which issues of climate predominate. This could risk a “fire sale” of these assets causing the knock-on effect of a financial crisis.

As 2020, gets under way, challenges to the global economy abound from many different quarters, some predicted and some completely unforeseen.

Ones that are unforeseen can prove to be the most disruptive as witnessed by the GFC in which a collapse in a barely-regulated derivatives market for household mortgages risked bringing down the entire global financial system.

Neither the International Monetary Fund (IMF) nor the World Bank provided early warning of the dangers ahead. This was left to individuals like New York University professor Nouriel Roubini who was one of few economists who pointed out the risks associated with trading in a merry-go-round of near worthless credit default swaps.

Global growth

Just how damaging the coronavirus contagion proves to be remains a matter for conjecture. However, early indications are it will constitute a much more serious drag on the global economy than the SARS outbreak of 2003. Then it was estimated disruption to travel and other forms of business caused by SARS represented a hit of $US40 billion on the global economy. SARS is estimated to have shaved 0.1 per cent off global GDP.

Much has changed since then, not least the size of China’s economy and thus its importance as the driver of global economic activity.

In 2003, China accounted for 4 per cent of global GDP. In 2020, its share is 17 per cent. Perhaps more important, China has been contributing one-third of global growth.

What also needs to be kept in mind is China’s importance to global supply chains is now much deeper than it was two decades ago. Companies like Apple are heavily dependent on their Chinese manufacturing facilities. Hyundai has just announced it has closed down production in South Korea because it can’t source key components from China.

If the global economy’s growth engine falters effects will be felt far and wide and nowhere more so than Australia.

These numbers reveal just how important China is to the Australian economy and its growth profile: in 2019, exports to China accounted for 34.3 per cent or $A118 billion of total Australian exports

Iron-ore and concentrates, coal, natural gas and gold represented the lion’s share of merchandise exports. On top of that education services and tourism accounted for an increasing chunk of Australia’s trade with China.

Education services and tourism together now rank second to iron ore and ahead of coal in trade statistics. Clearly, any further slowdown in China’s already slowing economy, or interruption to normal traffic, will have a deleterious on Australia’s own economy.

For example, ANZ Research released an update saying “we have revised our preliminary estimate of the impact of the coronavirus and now expect it to take around 0.5 percentage points off Australia’s GDP in Q1. Along with a small hit from the bushfire impact, we estimate GDP will now fall 0.1 per cent quarter on quarter in Q1”.

Budget impacts

The budget surplus confirmed as recently as December in the government’s mid-year economic and fiscal outlook (MYEFO) is now clearly at risk.

On top of the billions of dollars required for bushfire relief, Treasurer Josh Frydenberg is also being required to take account of the costs to the exchequer of lessening demand for Australian commodities and a fall-off in tourist traffic due to the coronavirus epidemic.

Australia welcomes 1.4 million Chinese tourists a year. That number has slowed to a trickle. Education numbers in which Chinese make up about one-third of overseas students at Australian tertiary institutions will be affected.

Investment bank UBS estimates the fall-off in tourist traffic alone could cost Australia $A1 billion in lost earnings.

But going back to this being now a known unknown, forecast differ. ANZ Research noted “there is a very wide a range of uncertainties around the outlook”.

“The virus’s timeline, the behaviour of non-China tourism, the impact on broader Chinese and global growth, and the degree to which Australian’s limit their travel abroad” are factors ANZ says. “While the hit to near-term growth is large, we expect the number of arrivals from China to turn around in Q2, with the rebound in tourism adding to growth in Q3 and Q4. Consequently, the impact on year-end growth is likely to be small.”

Damaging effects will depend on the longevity of the coronavirus epidemic and its geographical spread inside and outside China. Again, the spread is one of Rumsfeld’s known unknowns.

Even though the virus itself has been isolated by, among others, Melbourne’s Doherty Institute, it will take months to test and produce anti-viral medication.

China’s own economic growth will almost certainly be affected. Its economy was slowing in any case. It grew by 6.1 in 2019, down from 6.6 per cent in 2018. Chinese consumer spending will be well down in the first month or so of 2020. This will have a ripple effect globally whose duration remains difficult to predict.

What is certain is the IMF and World Bank will be obliged to revise their global growth forecasts.

As the coronavirus infected world consciousness in January, the IMF issued its World Economic Outlook for 2020 in which it forecast  a “tentative stabilisation” of the global economy and a “sluggish recovery”.

According to the IMF global growth would strengthen this year to 3.3 per cent from 2.9 per cent in 2019. Those numbers will now have to be revised.

Worst case scenario

Meanwhile, attention may have been diverted by the coronavirus episode from the BIS’s green swan warning but once the danger eases, central banks will almost certainly give more weight to the BIS paper.

In its advice, the BIS says “in the worst case scenario, central banks may have to confront a situation where they are called upon by their local constituencies to intervene as climate rescuers of last resort’’.

In a world awash with risk and reminded in this latest period of the difficulty of predicting what might lay ahead, what is certain is that uncertainty, or unknown unknowns, is set to happen more frequently.

Welcome to the third decade of the twenty-first century.

Tony Walker is a bluenotes contributor, former Financial Times correspondent in China and former Australian Financial Review political editor.

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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