By Louise McCabe and Michelle Lindsay.

Living at the end of the earth can have its benefits. While Australia and New Zealand were not immune from the effects of the Global Financial Crisis, we avoided the worst of the economic pain suffered by many of our OECD counterparts – rebuilding healthy economies on the back of robust banking sectors, strict regulation and strong demand for exports.

It’s tempting to believe that this dream run will last forever. But the reality is that any number of global events could impact both countries. The question is – which are more likely to do so, and how bad could it get?

Raging pandemics, resurgent protectionism and a global housing market collapse all have potential for worldwide havoc. But four scenarios stand out as having the greatest potential to damage Australia and New Zealand’s economies, often through their effects on the financial system.

1. Collapse of China’s banks

An oft-cited risk to the global economy is the potential collapse of the Chinese banking system. This concern is founded on the enormous debts to which Chinese banks are exposed – debt estimated at around US$29 trillion. If the Chinese economy continues to slow, some experts fear parts of this US$29 trillion debt pile could turn sour, causing the Chinese banking system to implode – with significant economic effects for the rest of the world.

So how bad is China’s debt problem? And how likely is it to cause a collapse?

If the Chinese economy continues to slow, some experts fear parts of this US$29 trillion debt pile could turn sour.

In recent years, China’s debt has been growing fast – increasing at an average rate of 20% between 2009 and 2015, according to the International Monetary Fund (IMF). Debt currently stands at more than 2.5 times the size of the economy, requiring around a third of its domestic product to service it. 

While a credit gap below four percentage points is widely considered low risk, China’s sits at 20–25 percentage points. This puts China in similar territory to countries that have previously experienced “painful deleveraging”, including Spain, Thailand and Japan.

In March this year, China’s central bank governor, Zhou Xiaochuan, conceded that debt levels are “too high” and need to be brought under control. However, it remains to be seen how effective China’s debt crackdown will be. Initial efforts to curb lending have fuelled the less regulated “shadow banking system”, now estimated to be worth around US$8.5 trillion.

Even if a debt implosion is averted, the IMF warns that unchecked debt levels can slow the Chinese economy from 6.9% in the first half of 2017, to 5% in 2021 – with far-reaching economic effects.

AMP Capital Chief Economist Dr Shane Oliver notes that China has contributed 30% of all global economic growth in recent years. “A sharp slowing in China’s growth would obviously have an economic flow-on,” says Oliver.

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Both Australia and New Zealand would be impacted, due to their exposure to China as a major export partner, with Australia’s resources sector particularly hard hit.

“China is [Australia’s] biggest trading partner. If its economy went into recession on the back of a banking crisis, that would clearly lead to a collapse in demand for our exports and a collapse in commodity prices.”

Nonetheless, Oliver believes a Chinese banking collapse is unlikely, due to the state’s high level of savings and foreign policy reserves – and its willingness to prop up heavily-indebted corporations.

“A lot of the lending was to state-owned enterprises. So, if there were to be a problem, the Chinese authorities would jump in as they have in recent years. But [for the system to fail] it would require the authorities to turn a blind eye, and I can't see that happening.”

2. War between the US and North Korea

Despite repeated attempts by the global community to get North Korea to abandon its nuclear weapons programs and recommit to the Treaty on the Non-Proliferation of Nuclear Weapons (NPT), the country shows no sign of changing its course. In fact, since 2011, under the leadership of Kim Jung-un, North Korea has developed greater missile and nuclear capability than ever before. 

The UN Security Council introduced sanctions against North Korea in September 2017. Meanwhile, North Korea’s leader Kim Jong-Il and US President Donald Trump continue to engage in a war of insults.

In really bad scenarios, where the North Koreans have used nuclear weapons, in the space of one afternoon we could lose Tokyo, Seoul, Pusan, Osaka.

So how concerned should we be about the risk of a North Korean conflict? Perhaps just a bit – or perhaps very concerned. It depends who you ask.

Dr Malcolm Davis is a senior analyst at the Australian Strategic Policy Institute whose expertise includes Asian security, strategy and capability development and Chinese military modernisation. He expects to see a resolution to the tensions as soon as 2018 – but probably not through diplomacy.

According to Davis, the leading diplomatic solution proffered by China and Russia is a “freeze for freeze”, where North Korea would agree to stop producing nuclear weapons and the US would end military exercises with South Korea. But such an agreement, he says, would be too easy for North Korea to break, and would see the US lose credibility with its Korean and Japanese allies.

In his view, it is more likely that we’ll see the tension escalate into conflict – with no easy options in sight. “The best case is a US attempt to decapitate the North Korean leadership of Kim Jung-un through a military strike,” says Davis. “This war would have two phases: a traditional warfare of high intensity, then a post-conflict phase, with a prolonged insurgency – similar to what happened in Iraq after 2003.” 

The worst case? A scenario where the North Koreans use nuclear weapons on South Korea and Japan – and potentially some US territories – causing widespread devastation.

“[This could] lead to death of millions … and the potential collapse of cities and certainly fallout spreading across much of north-east Asia,” says Davis.

While in theory, the North Korean regime has the capability to bomb Australia, Davis sees this as unlikely. And if there is a nuclear attack on South Korea and Tokyo, the fallout will probably head away from Australasia towards China, Russia and perhaps south-east Asia.

But the economic effect could be severe. “In really bad scenarios, where the North Koreans have used nuclear weapons, in the space of one afternoon we could lose Tokyo, Seoul, Pusan, Osaka,” says Davis. “How does that affect stock markets in a globalised, interconnected economy?”

Shane Oliver, on the other hand, believes diplomacy will prevail – and if military action does take place, he expects it will be brief. He expects any economic impact to be of a similar level to the SARS outbreak or a natural disaster, where there’s a dramatic but brief drop in sharemarkets – and then a rebound once the crisis is over.

“Assuming the war and exchange of missiles is short-lived, then you'd have a rebuilding effect very quickly,” says Oliver.

3. An attack on global cyber-security

Of all the scenarios, an attack on our global cyber-security environment may be the most likely. If it happens, it could disrupt the flow of capital, sap banks’ confidence in dealing with each other, spark public anxiety about deposits and initiate a credit crunch which would impact the broader economy in much the same way that the 2008 crisis did.

Tamara Evan manages the Centre for Risk Studies at the Cambridge Judge Business School at the University of Cambridge. She says an extended outage of a major banking system could put stress on global supply chains and even lead to social unrest.

Evan points out that a mass attack on an operating system has already occurred, with the deployment of WannaCrypt ransomware on more than 200,000 computers across the globe in May 2017. While a flaw in the malware allowed it to be neutralised and its impact contained, Evan says it was still able to disrupt key business and government operations. 

“Here in the UK, it crippled healthcare facilities,” she says. “It also shut down Renault plants in France, badly affected banks and government institutions in Russia, and caused business interruption elsewhere.” 

However, she stresses that the risk of a complete compromise of a core banking system is low. That’s because the banking platform technologies are at the cutting edge of cyber-risk management. 

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“Even a blip of inactivity – a few hours in length – would not facilitate the collapse of the global economy,” she says. “The system is resilient enough to accommodate a short outage.”

However, she says businesses need to protect against attack by educating their staff on safe digital practices and encourage a diversity of network technologies and backups. “In many ways, the advisable methods for protecting the economy against cyber risk are the same as protecting a population from disease – and it is antithetical to the way we tend to use technology for business.” 

Gernot Heiser is a Scientia professor at the University of New South Wales, where he examines fundamental solutions to cybersecurity challenges. He agrees that at present, a single compromise would be unlikely to break the entire banking system. However, he points out that operating systems are vulnerable to attack and government and business must remain vigilant against cyber-attack by increasingly sophisticated hackers and hostile nation states.

“Attacks on general infrastructure, whether the power grid or banking, could have really devastating effects,” he says. “In some cases, it might take days or weeks to recover.”

4. The impact of climate change

Climate change is in many ways the most predictable of disaster scenarios: most climate experts believe human-created greenhouse gases are warming the planet, and most countries have signed up to the Paris Agreement try to limit global temperature rise to below 2ºC. But will this action be sufficient?

Dr Stuart Palmer is Head of Ethics Research at Australia Ethical, an ASX-listed ethical wealth manager. Dr Palmer says that even if the world meets its Paris targets, there will still be consequences: “some sea level rise, more extreme weather events and problems accessing water”. That will make certain regions unviable for growing crops, he says.

Extreme weather events, in particular, have ranked at the top of the World Economic Forum’s list of global risks over recent years. Not only do these events disrupt economies, but some analysts fear frequent extreme weather events could destabilize the global insurance industry by requiring a series of large payouts.

In Palmer’s view, the worst-case scenario would occur if the world retreats from its Paris obligations. “We could see 3ºC to 6ºC warming, widespread loss of productive food-growing regions, and sea level rise of 1-2 metres this century, making vast low-level regions uninhabitable.”

Fortunately, he thinks this worst-case scenario is unlikely. What’s more, he says, investment to address climate change in sectors like energy, agriculture and transport will lead to returns over time.

Shane Oliver agrees the likelihood of climate change impacts is high, with severe bushfires and storms the primary threats in Australia. However, beyond short-term disruption, he doesn’t see them fundamentally damaging the economy. He sees rising sea levels as a greater threat, but believes their effects won’t be felt until well beyond the next decade.

Reasons to be optimistic

Shane Oliver says that while businesses should be aware of potential global risks and their economic impacts, we should not descend into pessimism. He cites the fact that the Australian share market has gone up eight years out of 10, while US stocks have risen seven years out of 10. 

In Oliver’s view, predictions of crashes and disasters may drive fear and sell new books – but most don’t eventuate.

“In 1949, we knew was a growing risk of nuclear warfare of the Soviet Union,” he says. “If someone took that as their base case, and had hidden under a rock or in the mountains, they would have missed out on the post-war economic boom, which saw shares surge for decades into the early ‘70s and massive expansion of economic growth around the world.”

“You’ve got to allow for tail risks but you shouldn't let them drive the base case – which is invariably that things turn out okay.”

Australia now ranks sixth in world prosperity rankings, down from second place in 2007, according to a new report from CA ANZ.