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As investors scramble for yield in markets awash with central bank liquidity, their eyes continue to be drawn toward the glitter of emerging markets, including those in the Middle East and South Asia, where I’ve been trolling for the past few weeks to probe the links between portfolio strategy and tail risk. Few countries offer as much fertile ground for such ruminations as Pakistan.

The Islamic Republic has its own special charm for diplomats, soldiers and spies, who worry about different risks emerging from the country and its growing stockpile of nuclear weapons. But below the Bloomberg radar, Pakistan may also have the potential to perturbate global financial markets. My time in Islamabad was brightened by winter sunshine and darkened by conspiracy theories.

“Assassinations, mayhem and lack of rule of law in some emerging-market locations often make them a marginal sideshow to global macro markets,” says Thomas McGlade, portfolio manager at London-based hedge fund Prologue Capital. “Even Syria can hardly get the attention of the markets, so the low boil that is constant in Pakistan rarely registers. But it’s the security and nuclear dynamic which could push Pakistan to the forefront.”

My diplomat friends aren’t eager to see a crisis in Pakistan, but some traders take a different view. Global macro hedge funds are starving from a lack of volatility, which is their lifeblood. Europe’s financial markets have healed dramatically since Mario Draghi promised last year to do whatever it takes to save the euro. The decision by Washington lawmakers to avoid any fiscal cliff–diving has provided a similar tonic on the other side of the Atlantic. China’s policymakers have engineered a soft landing for their economy. The civil war in Syria hasn’t spilled over into instability in the Gulf or posed a threat to global oil supplies. And on top of it all, central banks in Europe, Japan, the U.K. and the U.S. continue to pump liquidity willy-nilly into global financial markets, forcing everybody into higher-risk, higher-return assets.

All in all, it’s a pretty benign environment for the global economy but one that makes macro traders squirm. Returns at many hedge funds lagged their benchmarks in 2012, and a lot of investors are still smarting about the 2 percent fees. “We could really use some volatility right now,” one London-based trader complained to me over a curbside lager at a Mount Street pub in Mayfair. “It’s hard to make money when things are this quiet.”

And so macro traders have their ears to the ground for the first rumblings of turmoil. “There is still a desire to find, or anticipate, the next ‘tail event,’ and there certainly will be others going forward,” says Adam Crisafulli, head of market intelligence at J.P. Morgan in New York.

A couple of traders in New York and London told me that Pakistan was on their list of prime candidates for tail risk. I found this intriguing since I was headed there anyway. How much of this perception is real and how much is the cinematic reflection of Zero Dark Thirty, the gripping Kathryn Bigelow movie about the search for Osama bin Laden?

(Not that I’m immune to cinematic reflection nor to what I thought was Bigelow’s sympathetic portrayal of my former CIA colleagues. The film’s bombing scene at the Islamabad Marriott prompted me to stroll over and have tea at the hotel’s lounge, for old time’s sake. Navigating the Hesco barrier gauntlet and double-thick blast walls that were erected after the actual 2008 attack was a minor hassle, but no more so than trying to enter any U.S. embassy in this part of the world.)

On my way to Pakistan, I heard plenty more risk scenarios on a stopover in Dubai. The iPhone told me it was freezing in New York and snowing in London as I smoked shisha, or flavored tobacco, by the pool of a luxury hotel with a random scrum of traders, investors, entrepreneurs, retired diplomats, soldiers and people who describe their work simply as “export and import.” We bathed in the reflected light of the Burj Khalifa tower on a balmy 20 degree Celsius evening. I confess that I haven’t enjoyed a hookah so much since 1973. And yes, I inhaled.

According to portfolio managers, an emerging market like Pakistan could trigger one or more of four possible convulsions that would jolt markets.

For starters, something really bad could happen in an emerging market that would derail GDP growth in one of the bigger BRICS. The obvious risk here is a Pakistani economic implosion with spillover effects on its Indian neighbor. The economy enjoyed several years of nearly 7 percent growth in the mid-2000s under the leadership of reformist prime minister Shaukat Aziz, but political instability and mismanagement have sapped its strength in recent years. The assassination of former prime minister Benazir Bhutto in December 2007 unleashed a wave of violence, including the 2008 Marriott bombing. Bhutto’s widower, Asif Ali Zardari, won election as president in 2008, but subsequent governments have failed to pursue reforms, crack down on corruption or get a grip on the deficit; foreign investment has slowed to a trickle. The result? Growth has averaged only about 3 percent a year since 2008 and is projected by the International Monetary Fund to be a sluggish 3.25 percent in the fiscal year ending June 30.

There’s also the possibility that a South Asian crisis could interrupt the smooth flow of petroleum from the Gulf. Unlike Iran, however, Pakistan isn’t in a position to choke the Strait of Hormuz. To the contrary, in January the Pakistan Navy engaged in joint naval exercises with the Royal Saudi Navy to help secure the Gulf passages and the Horn of Africa against Iranian interference and Somali piracy. Moreover, the Pakistanis are close to being choked themselves. Many of the offices and residences in Islamabad are unpleasantly cool in the evening chill; there isn’t enough natural gas to turn on the heaters because the national oil company is virtually bankrupt. There are quarter-mile-long queues at every gas station. So this aspect of Pakistani tail risk is vanishingly low, in my view.

Alternatively, a terrorist attack linked in some way with an emerging market’s domestic struggle could spook markets, particularly if the epicenter is Canary Wharf or Wall Street. Pakistan is still the center of gravity of the global Al Qaeda network, even after bin Laden’s removal. (As I walked back from the Marriott, it struck me that the CIA analyst played by Jessica Chastain in Zero Dark Thirty is a full generation younger than my former colleagues who supported the Afghan mujahedeen proxies against the Soviets and did so hand in glove with Pakistan’s Inter-Services Intelligence Directorate, the ISI.)

At the far end of the scale, and most ominously, a nuclear event would trigger raw market panic. Pakistan is on its way to becoming the world’s fifth- or sixth-largest nuclear power. The prospect that one of those weapons could fall into the wrong hands, intentionally or not, is one of the few things that actually keeps me awake at night.

After a three-hour hop across the Gulf, I arrived in Islamabad and found the capital cool and much less tense than on my prior trips. It’s quiet because occupancy is down, explained the manager at the Serena Hotel. The day before I landed, Imam Tahirul Qadri, a centrist cleric who advocates good governance, disbanded 100,000 protestors who had flooded the streets threatening to storm Parliament if the government of Prime Minister Raja Pervaiz Ashraf didn’t promise new elections and “throw out the corrupt politicians.”

It’s cool because the sun rises late over the steep, arid limestone Margalla Hills that frame the city to the North. Islamabad itself is a sprawling, dusty metropolis; its once-grand municipal fabric and splendid ministry buildings show the effects of poor maintenance, economic stagnation and the occasional suicide bombing.

There are checkpoints everywhere, staffed by police, and Pakistan Army Rangers in olive-drab, long-shirttailed shalwar kameez nervously fingering their AK’s as they huddle around burning logs in the evening chill. They stand up to shine a flashlight into the passing cars; then they usually smile back, lower their guns and return to their sandbagged fireside. I confess to ducking low in the front seat one evening as a diplomat friend blithely waved to an anxious pair of Rangers as she weaved her battered Toyota through a concrete block checkpoint without braking.

Such frissons aside, I am fond of the city and its attractive residents — resilient, clever, funny and hard working. They manage to enjoy life in the face of adversity and poor governance. During my visit, Islamabad’s buildings were draped with elaborate festive patterns of lights in the evening, celebrating Milad an-Nabi, the Prophet’s birthday. Miraculously, these nighttime filigrees defy the rolling brownouts and random power outages. The Ministry of the Interior looked like Manhattan’s Tavern on the Green at Christmas.

What is the probability that Pakistan will generate one of the four tail-risk events that would move global markets? What would be the timing and magnitude of such an event, and what might be the early warning indicators — against the backdrop of a falling or failed state?

After a couple of days in Islamabad, it seemed to me that Pakistan is tracing the slow-motion trajectory of a failing state, if not yet in free fall. An international bank economist talked me through the statistics over chai, with deeply felt distress.

“We have at least five structural crises here in Pakistan, and they are all interconnected,” this economist said. “First, revenue mobilization is low. The ability of the state to collect taxes is the second-lowest in the world, just slightly above Guatemala.” Another economist spelled out the consequences. “A country which collects a stagnant 8 to 9 percent of GDP in tax revenues does not have much of a future because it will never have the resources to finance essential social and physical infrastructure,” said Meekal Ahmed, former chief economist of the IMF’s Planning Division.

The second problem is electricity, or more precisely, as I watched the lights in my hotel room flicker out until the backup generators kicked in, the lack of it. “The electricity system in this country has been dysfunctional for ten years,” said the international economist. “The tariffs are set below the cost of production, 30 percent of the power current is stolen en route, and 50 percent of the customers that actually receive electricity refuse to pay up — especially the state-owned enterprises.”

Depressingly low investment in human capital is the third and the most ominous of the problems. Pakistan has the lowest indicators for health, nutrition and education in South Asia. There are 50 million illiterate adults in Pakistan today and 25 million children who do not attend school, half of who are between the ages of five and ten. The bank economist was particularly concerned about the health part: “If you don’t intervene with good nutrition within the first 24 months of life, the children will remain mentally and physically stunted for life.”

The fourth problem is the persistence of natural, as opposed to man-made, disasters. Pakistan has had a major flood, fire, earthquake or drought every year for the past five years. “The destruction of physical capital is just enormous,” the bank economist said. The 2010 flood alone inflicted $10 billion worth of damage. “You can’t recover from these disasters without big government expenditure. And you can’t protect yourself from future floods without big investments in dams and canals, which takes years — and tax revenues you don’t have.”

The fifth problem is poor governance, against a backdrop of persistent political chaos. The coalition government led by President Zardari’s Pakistan Peoples Party (PPP) is widely acknowledged to be ineffectual and corrupt. (Zardari’s reputation for corruption when his wife was prime minister in the 1990s earned him the nickname Mr. Ten Percent.) “In the run-up to the May election, there is no debate on serious matters of governance for economics. It’s all about identity and personality, tactical advantage and scoring ideological points,” the bank economist said, despairingly.

Meanwhile, the country is riven by sectarian, ethnic and regional separatist fault lines, against the backdrop of uneasy relations between the civilian leadership and the military. Most observers discount the odds of another coup, but many believe that Imam Qadri was actually fronting for the Army. In Pakistan’s conspiracy-driven political culture, no simple explanation will ever do if a more baroque theory can be invoked.

Could Pakistan melt down under the pressure of those structural crises, and possibly drag India down too?

Some indicators suggest a sanguine view. The Karachi Stock Exchange has been a lucrative bet for foreign investors lately. Over the 12 months to February 7, the KSE 100 index increased by nearly 42 percent, to 17,383, a gain that has been only partly eroded by the rupee’s 18 percent depreciation, from 86 to 98 to the dollar.

Yet Pakistan’s economic growth rate is limping along at just 3.7 percent, a far cry from the 7 percent-plus rates that prevailed from 2004 to 2007 and less than half the rate required to absorb new entrants to the labor market. The fiscal deficit stands at 6.6 percent of GDP. The current account is faring better; it was in the red by just $2.3 billion last year, or about 1 percent of GDP, thanks to nearly $5 billion in remittances sent home by Pakistanis laboring abroad, many of them in Dubai and around the Gulf.

Do the math. Foreign exchange reserves are dwindling slowly but steadily, from $10.5 billion in June 2012 to $8.8 billion today, covering a mere 60 days worth of imports. The Ministry of Finance is living hand to mouth on the largesse of the IMF and the World Bank, hoping for yet another bailout contingent on yet another unmet set of economic conditions. “The IMF team left town last week, and they weren’t happy,” a local reporter told me. In other words, the government is staring down the barrel of a classic balance of payments crisis.

This crisis may be different from past ones in two respects.

First, the IMF may not blink and bail out Pakistan this time. Christine Lagarde’s firefighters remember a long string of broken promises from Islamabad. And there are a lot of struggling economies in the IMF queue, including the euro zone’s peripheral states. The hearts — and wallets — of IMF shareholders have been hardened by three years of euro crises. “Why should German taxpayers support Pakistan’s fiscal deficit when Pakistani elites and business don’t pay taxes themselves?” asks a European diplomat, rhetorically.

Pakistan and the IMF have decades of mutual disappointment in what Ahmed, the former IMF economist, calls “stop-start adjustment.” As he himself observed first-hand, “An IMF program gets some reforms implemented as part of its conditionality, but then as soon as the program is over or ended by the authorities themselves, all the reforms are rolled back. At the next program — and there is always another IMF program lurking down the road — the charade is repeated.”

Second, Pakistan’s economy may not be able to adjust even if they are bailed out. The neoclassic adjustment model requires Pakistan to increase exports on the basis of a depreciated currency and deflated domestic prices. But what happens if the electric grid remains broken and the population malnourished? How do you make labor-intensive manufactured goods in factories without power and at least minimally educated and healthy workers? How do you ship these goods to a port or airport with a broken transportation infrastructure? How do you get foreign manufacturers to build factories in Pakistan in the first place in the face of unenforceable contracts, relentless extortion and pervasive insecurity?

For evidence, look no further than Karachi, the country’s largest city and vital port. “The great battle for Pakistan may be fought in Karachi, nerve center of Pakistan’s semicomatose economy,” says local Newsweek reporter Khaled Ahmed. “The Taliban first warned they would soon be masters of the city, then proved it in December through targeted killings and extraction of protection money, successfully challenging police and Rangers who have tacitly accepted certain localities as no-go areas.”

The daily mayhem is surprising even to me, inured by frequent visits to Afghanistan. On one day during my visit, the newspaper Dawn reported 12 murders the day before in Karachi alone, including a senior police inspector and Dr. Syed Hasan Alam, the superintendent of the New Karachi Hospital. Both were shot by motorcycle-riding gunmen. Shia are disproportionately represented in the medical profession; 80 Shia doctors have been assassinated in Karachi. It’s little surprise that so many talented Pakistani professionals and entrepreneurs have fled abroad.

“To the litany of slow-motion potential-failing-state indicators, add the quiet but steady flight of intellectual capital,” notes Reuben Jeffery III, CEO of Rockefeller Financial, the New York City–based wealth management firm, and a former under secretary of state for economic, energy and agricultural affairs. “The brain drain of the middle and entrepreneurial classes tears at the fabric of both civil society and the economy.”

Pakistan’s plight makes Greece’s rocky adjustment to fiscal austerity, with its strikes, chaos and violence, seem mild by comparison. And the IMF is less pliable than the European Central Bank. “I’d say the odds of a payments crisis are low today, medium in April and high by September,” says an international banker.

Bond markets already reflect much of that risk. “Pakistan’s credit spreads are around 750 basis points over U.S. Treasuries,” says Eric Fine, an emerging-markets portfolio manager at Van Eck Global in New York. “This puts it in a group with Venezuela, at 620 basis points over, and Ukraine at 570 basis points over.” Fine ticks off a daunting list of threats: “In Pakistan you have risks of ongoing radicalization of politics that might be unstoppable given the momentum of U.S. and European policy. You also have low reserves, high spending, difficulty with revenue collection and a growing current account deficit. The IMF can’t be counted on to bow to the geopolitical concerns of its major shareholders as it has in the past, given the country’s poor performance in previous programs and growing claims on IMF funds. So, my bottom line is that in Pakistan you have a nontrivial risk of a liquidity crisis, no easy policy answers to satisfy the IMF and a pretty illiquid bond market. If things go wrong, the market will likely overreact.”

What early warning indicators should macro traders keep their eyes on for a balance of payments crisis? “Pakistan’s national accounts are poor and bear only a passing resemblance to the reality on the ground,” noted Meekal Ahmed. So, for an enterprising trader to get the timing right, he or she will need to construct a macro model based on more reliable third-party data sources, inferring economic activity from indicators such as coal imports or textile output — not unlike trying to figure out China’s real growth rate.

Might a Pakistan balance of payments crisis spill over to India, blunting growth or destabilizing the financial system of its neighbor? On this score, at least, the tail risk is minimal. Two wars, six decades of tense confrontation and regular shooting incidents in Kashmir like the one in January, which left soldiers dead on each side, have kept Indo-Pakistani trade and investment visibly small. Bilateral trade volume is a modest $2.5 billion per year. A lot more trade and finance undoubtedly is routed through Dubai and other Gulf outposts, but basically the two economies and their respective banking systems might as well be on far sides of the earth.

Yet as Rockefeller Financial’s Jeffery observes, “India and Pakistan are separate economies perhaps, but with contiguous geographies, substantial population concentration (about 1.4 billion together) and competing nuclear programs. Make no mistake about it, Pakistan and India are separated by the thinnest of margins for strategic nuclear miscalculation.”

The terror plots that culminated in the 2005 London Underground bombings and the failed car bomb attempt in Times Square five years later were both hatched in Pakistan’s lawless border regions (and, incidentally, both figured briefly in Zero Dark Thirty). This risk is no abstraction. Markets react badly to terrorism, particularly if it blows out windows in a financial center.

Pakistan has made persistent use of proxies in the conduct of its foreign policy. To the east, government forces armed and trained thousands of irregulars to conduct their decades-long guerilla war against what they describe as the Indian occupation of Kashmir. These groups have struck elsewhere, in Mumbai and even the Indian Parliament in Delhi.

To the west, Pakistan has provided sanctuary and support for the Taliban, particularly the infamous Haqqani network. I was in Kabul in October 2009 and heard their suicide car bomb explosion between the Indian Embassy and the Ministry of the Interior; we were trudging around in shattered glass shards for days. According to The Long War Journal, this was the work of the Haqqanis. A year earlier they had attacked the Kabul Serena Hotel in a senselessly brutal strike; they staged an assault on the Kabul InterContinental Hotel in 2011. It's little surprise that in September 2011, former chairman of the Joint Chiefs Mike Mullen described the Haqqanis as a “virtual arm” of Pakistan’s ISI in Congressional testimony.

What are the proxy terror spillover odds, to Mumbai, London or even New York? Pakistani diplomats protest, insisting that the country has had a sea change in attitude. They claim that civilian and military leaders alike now understand that these proxies, particularly the Taliban, are now targeting the Pakistani state. But some Pakistani observers are skeptical. “You can’t have a policy of the good Taliban who are fighting in Afghanistan and the bad Taliban who are fighting in Pakistan,” says Ahmed Rashid, a prominent journalist and author of Pakistan on the Brink. “They’re all Taliban. We need a comprehensive counterterrorism strategy, or we will continue reap the bitter harvest.”

But unless Pakistan truly rejects proxy terrorism, the odds of a spillover event aren’t very far out on the tail. The risk drops as a function of the distance from Karachi, I suspect, but not to the zero asymptote: It is dangerously high in Amritsar, Delhi, Mumbai and Bangalore; unsettling in Dubai, Bahrain, Beirut and Istanbul; and high enough in Milan, Paris and Frankfurt to keep the European intelligence agencies on their toes. London is in a risk class all its own, with tens of thousands of Pakistani-Britons traveling between South Asia and the U.K. every year.

Pakistan’s fiscal squeeze and economic problems are linked to the risks of terrorism and nuclear proliferation in a particularly dangerous way. The worse the economic performance of the Islamic Republic relative to India’s, and the lower the tax flow to the state, the further Pakistan falls behind in terms of conventional weapons. The weaker Pakistan’s conventional forces, the more they will fall back on the asymmetrical strategy that relies on nuclear deterrence on the top end of the force spectrum and terrorist proxies on the low end.

The Arms Control Association estimates that Pakistan has between 90 and 110 nuclear weapons already, and they are building more reactors to make more. ”Islamabad is more than ever committed to nuclear weaponry as the ultimate guarantor of national security,” says Feroz Hassan Khan, a former director of arms control and disarmament affairs for the Pakistan military, who now lectures at the Naval Postgraduate School in Monterey, California. “Its nuclear strategy remains of tight command and control, minimum credible deterrent posture, and ambiguity in doctrine of use and force postures for the foreseeable future.” That’s hardly a confidence booster in my view. And interlocutors in Islamabad confirmed the Army’s intention to deploy tactical nuclear weapons, which raises the risk of “loose nukes” and early use. How’s that for Reuben Jeffery’s risk of “nuclear miscalculation?”

The world’s most dangerous nuclear proliferation network is operated from Pakistan under the leadership of Abdul Qadeer (A.Q.) Khan, the father of Pakistan’s nuclear program. He worked hand in glove with the North Koreans, Libyans and Iranians. A.Q. Khan is, by the way, a folk hero in Pakistan. Islamabad’s high court released him from house arrest and formally declared him “a free citizen of Pakistan.”

The nexus between terrorist groups and Islamic militants is rarely brought up in Pakistani politics. Few politicians are brave enough to take them on, and these groups still have ties to the ISI, as the trials of the Mumbai terrorists have revealed. Lashkar-e-Taiba, the terrorist group behind the Mumbai attack, and Lashkar-e-Jhangvi, which has focused its attacks on Pakistan’s Shia community, may have changed names, but they are still in business, even as Zardari eases, in fits and starts, towards détente with India. In other words, the asymmetric strategy of using proxies as well as nuclear weapons has considerable inertia.

As Prologue’s McGlade points out, “If the state fails, or falls to an extremist government, or looses or uses a nuclear device, the fate of Pakistan could be a huge deal for financial markets.” As for the London global macro trader hoping for some more volatility, Pakistan or its proxies may well oblige. But there is wisdom in the cautionary phrase: Be careful what you wish for.

James Shinn (jshinn@princeton.edu) is lecturer at Princeton University’s School of Engineering and Applied Science. After careers on Wall Street and Silicon Valley, he served as national intelligence officer for East Asia at the Central Intelligence Agency and as assistant secretary of defense for Asia at the Pentagon. He is CEO of Teneo Intelligence and serves on the advisory boards of Oxford Analytica and CQS, a London-based hedge fund.

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