Adding a fair degree of pessimism to an already pretty gloomy world outlook, in its latest annual report on global risk, the World Economic Forum (WEF) came to an abrupt conclusion: in 2008, the world will suffer from the highest levels of political and economic uncertainty for a decade.

The US-sourced liquidity crunch will almost definitely spark a US recession in the next 12 months, states the WEF, with possibly dangerous consequences for some countries.

It adds that economists are divided on whether consumption-led growth in Asia can drive the global economy; in Europe, the prominence of the UK’s financial sector makes it vulnerable, while large current account deficits in some central and eastern European economies may prove increasingly unsustainable in 2008.

The report, published on 9 January, calls for “new thinking on systemic financial risk in response to the revolution” in financial markets over the past two decades.

It says that the significant changes in the financial markets over the past two decades have led to the ownership of risks being highly decentralised, along with greater opportunities for risks to transmit between individual firms and markets – making effective risk management all the more critical.

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Four main risk factors

The study, Global Risks 2008, focuses on what it says are the four main risk issues which will impact the world economy and society in the decade ahead: systemic financial risk; food security; supply chain vulnerability; and energy risks.

While many of these cannot be avoided, they can be better understood, managed and mitigated, argue the report’s authors (it has been written in co-operation with Citi, Marsh & McLennan Companies, Swiss Re, the Wharton School Risk Center and Zurich Financial Services).

In terms of systemic financial risk, the report states that while a re-pricing of risk in financial markets was predicted by some observers at the beginning of 2007, the scale and nature of the systemic financial crisis of 2007-2008 has “raised fundamental questions as to the vulnerabilities within the current model of financial markets”.

Diversification of risk may have strengthened stability in good times, says the report, but systemic financial risk remains “acute”. In a statement, David Nadler, vice chairman, office of the CEO at Marsh & McLennan Companies, said: “Systemic financial risk is the most immediate and, from the point of view of economic cost, most severe risk facing the global economy.

“With so many potential consequences of the 2007 liquidity crunch unresolved, the outlook at the beginning of 2008 is more uncertain than it was a year ago. The US Federal Reserve has projected direct losses related to sub-prime of $150 billion; non-subprime financial losses may be considerably greater.”

Under normal market conditions, the financial system has improved its capacity to assume and distribute risk, and has become more stable, says the WEF.

But to mitigate the impact of the types of challenges seen in 2007, the report calls for increased public and private sector collaboration on stress testing, liquidity management, risk assessment and prevention in order to address what it describes as the “fragmentation of ownership of global risks”.

Country risk management

The report also recommends a set of principles for country risk management and examines how the financial sector might take on an increasingly important role in risk transfer in the future.

Despite the financial turmoil of 2007, the report says that financial markets are seen as an increasingly important tool to transfer and mitigate an increasing variety of global risks.

The growth of financial markets has opened up new possibilities to help mitigate risks, including the rapid emergence of a new market in insurance-linked securities (ILS), which help provide additional capital to the insurance industry to protect against major catastrophe losses.

The ILS market has grown considerably in recent years in the range of risks covered, with total bonds outstanding now at more than $34 billion.

“In order to maintain the benefits of globalisation, improved governance of globalisation is vital,” said Charles Emmerson, associate director of the WEF and editor of the report.

“In all the focus areas of this year’s report, principles of equity, management of trade offs and long-term global cooperation will be necessary. The short-term outlook is highly uncertain in 2008, but we must not lose sight of longer-term challenges.”