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World Risk Developments - November 2011 (2Mb)
Crisis escalation puts eurozone at crossroads
The eurozone crisis continues to escalate, with problems spreading from the periphery to the core. Italy is now on the verge of losing market access and may need to seek a bailout, if not writedown. The exit of some countries is no longer unthinkable. The key to stemming the immediate debt crises, if not keeping the eurozone together, is in the hands of the European Central Bank (ECB).
An EU deal agreed on 27 October designed to build a ‘firewall’ round the periphery has failed. This proposed that private bondholders take a 50% 'voluntary' haircut on Greek debt; European banks recapitalise themselves by €106 billion (US$148 billion) by June 2012; and the European Financial Stability Facility (EFSF) be geared up to €1 trillion. The deal seems to have foundered on a variety of things – uncertainty about whether bondholders would accept their haircut and about how the EFSF gearing would be achieved. Above all, there is concern that the EFSF, even after gearing, isn't big enough to bail out all the governments and banks that might need it for support.
So just 48 hours later, investors began to dump their holdings of Italian government bonds. Italy is a borderline case – a country that at low interest rates looks fiscally solvent, but at high rates insolvent. It is thus prone to a self-fulfilling crisis – if the market thinks Italy will get into difficulty it will demand a high risk premium that will in turn bring on the difficulty. That is the vicious circle the country is in now.
On 8 November yields on Italy's 5-year and 10-year bonds breached 7% after LCH Clearnet, a London clearing house, raised the margin on Italian debt. A 7% yield is considered unsustainable; Portugal and Ireland were forced to seek bailouts after their borrowing costs reached 7%. This level was breached even though the ECB had reportedly been buying large volumes of Italian debt to damp the yield.
In a further unsettling development overnight, investors also began to sell Belgium, Spain, France, Holland, Austria and Finland, taking their spreads over German bunds to unprecedented levels.
Although the government reportedly doesn't need to go to the markets for funding this year, it has €300 billion in bills and bonds maturing in 2012. If the yields don't come down, it could be forced to seek a bailout from the EU and IMF. The snag is: that would overwhelm the available resources of both bodies. So the ECB would come under pressure to fund the government instead. It is resisting this on three grounds: it would be inflationary as it involves monetary financing; it would erode the solvency of the ECB as it involves the purchase of risky bonds; and it would create moral hazard, tempting governments into fiscal irresponsibility.
The counter-arguments are: deflation is more of a threat than inflation and in any case the bank can sterilise its monetary emissions; the bank can recapitalise itself and is in any case less likely to suffer decapitalisation if it intervenes decisively to contain yields; and the moral hazard argument is exaggerated – governments experience severe pain even if they are bailed out. Above all, the mere threat to deploy the 'Big Bazooka' of unlimited monetary financing should be enough to cow market speculators into submission. Paradoxically, by threatening to buy unlimited amounts of Italian paper the ECB might have to buy little, maybe less than it is doing now.
Though the ECB will come under mounting pressure to undertake monetary financing if the alternatives fail, it can't be taken for granted that the Bank will agree. For a start, a majority of the Bank’s governing council reportedly opposes the ECB becoming an unqualified lender of last resort to governments. Second, even if the Bank’s opposition is overcome by the failure of the alternatives, the lender of last resort role would probably be challenged in the courts. So this raises the risk that the Big Bazooka is kept under wraps and the Italian government is forced to unilaterally restructure its debt; in other words, tell bondholders with maturing debt that they will be repaid over an extended period rather than at once, and at an interest rate it deems affordable.
But even if the ECB does act as a lender of last resort to Rome, would that put an end to the crisis and allow the eurozone to resume business as usual? It would bring the liquidity problem to an end, but it would still leave the debt-troubled countries with uncompetitive cost structures. With their public and private sectors heavily burdened with debt, the only chance of economic recovery comes from their external sector – export and import-competing industries. If they had their own currencies, they could depreciate to restore competitiveness and export their way to recovery. But the eurozone rules out depreciation. So they are faced with protracted and painful internal devaluations instead. This could lead them to conclude that leaving the eurozone is the lesser of two evils – much as Argentina decided to abandon its peg to the US dollar in 2001.
What could the eurozone do to lessen the cost of internal devaluation and make continued eurozone membership more attractive to Italy and other troubled countries? The ECB could lower interest rates further and induce a euro depreciation. And strong core countries like Germany could arguably inject some fiscal stimulus into their economies as the periphery is retrenching. But such a level of collective action seems unlikely. So this leads back to the conclusion that the eurozone is under considerable strain.
Thai floods disrupt international supply chains
Thailand’s position as a manufacturing hub for cars and electronics means that the recent floods will have effects beyond its borders.
The floods have submerged one-third of the country. In response, the Bank of Thailand has slashed its 2011 growth forecasts to 2½% from 4%. With the floods now threatening the centre of Bangkok and the wider metropolitan area accounting for 40% of national output, further revisions to GDP are likely. At this stage, ratings agency Moody’s estimates the cost of the disaster as equivalent to 2% of GDP; others put it nearer 3%.
Despite the damage, the flooding is likely to impose only a temporary drag. Most analysts are confident growth should recover in 2012, as the waters recede, reconstruction begins and manufacturing rebounds. Government spending will help. The government has already put aside 130 billion baht (1.3% of GDP) to help victims and repair infrastructure. A larger 600 billion-800 billion baht ‘New Thailand’ package (equivalent to 6-8% of GDP) has also been proposed to cover immediate reconstruction needs and flood prevention. This will be important to encourage manufacturers to stay put.
The direct impact of the flooding on world growth will be small – Thailand accounts for only ½% of world GDP. But the indirect effects could be larger, because Thailand is a regional hub for electronic and car manufacturing. It is also a major rice producer.
- Reminiscent of the Japanese earthquake in March, Toyota, Honda and Nissan have scaled back their production due to component shortages.
- PC producers are concerned about the availability of hard drives. Thailand produces 40% of the world’s hard drives and reports suggest that it could take six months for Western Digital – the world’s largest producer of hard drives and the hardest hit by the floods – to regain full production.
- The UN believes the flooding could boost rice prices. Thailand accounts for one-third of world rice exports and approximately one-quarter of Thailand’s annual output has been lost. Flooding has also hampered rice production in Vietnam, Cambodia and the Philippines.
For background on Thailand, please see the updated country profile.
Rapid growth strains Indonesian infrastructure
Strong economic fundamentals are helping to cushion the Indonesian economy from the eurozone crisis, but mounting infrastructure shortfalls could crimp the economy’s medium term growth.
The economy sailed through the global financial crisis, growing by 4½% in 2009, and continues to prosper – it will probably expand by about 6½% this year. It has many advantages – the world’s fourth largest population, a favourable demographic profile, a growing market in China and India for its coal and farm exports, and a stable political situation. There are reports that it will soon gain an investment grade credit rating.
Still, a large and growing infrastructure deficit is threatening to retard growth. The government estimates investment needs for infrastructure development over 2010-14 will reach about 1.9 trillion rupiah (roughly US$214 billion), about a third of which is expected to come from the private sector directly or through PPP arrangements (Chart 2).
In the longer term, the government wants to increase infrastructure investment significantly as part of a master plan for 2011-25. This plan outlines 4 trillion rupiah (roughly US$468 billion) in investments to be made over the next 14 years, with the central government and state owned enterprises expected to tip in around a third of the funding.
The remaining private sector funding might be hard to find. The government is already facing a shortfall in private funds for its 2010-14 National Development Plan. In part, this reflects infrastructure-specific problems such as red tape and a stalled land acquisition bill meant to resolve overlapping land claims. But it also reflects a perception that the returns on offer in sectors such as resources are larger and quicker.
Widening current account deficit leaves Turkey exposed
Turkey is becoming increasingly vulnerable to external shocks because of its high current account deficit and a tilt towards short-term funding to plug financing gaps.
There are clear signs that the economy is slowing after a blistering first half of the year when it expanded by 10.2%; industrial production and car sales, for instance, suggest that the economy is cooling but not crashing. The central bank thinks this will be enough to avoid a hard landing next year and will help to rein in the current account deficit, which has widened to 10% of GDP. But others, notably the IMF, are not so sure – the Fund expects that growth will slow to 2½% next year because of a less favourable external environment, which could limit Turkey’s ability to tap offshore funding. According to the central bank, Turkey’s external financing needs are likely to be around US$200 billion this year (roughly 27% of GDP).
So far, Turkey is managing to fund itself despite a generalised pull-back from the emerging market asset class . But it has had to rely increasingly on short-term funding, particularly the short-term external financing channelled through the banking sector (Chart 3). This is a key vulnerability because it exposes banks to rollover risks that could force them to curtail private sector credit in a downturn.
Argentine government ignores economic imbalances, imposes capital controls
The government has moved to head off a balance of payments crisis with capital controls.
President Cristina Kirchner was re-elected last month by a wide margin for another four years. Her party also secured majorities in the lower house and senate. Supporting her re-election were high agricultural prices and pre-election spending – government spending rose by 45% over the year to August. These factors pushed the economy along at a rapid rate – GDP grew by 9% in 2010 and 8½% in the first six months of 2011 – and drove unemployment down to record lows.
But the government’s strategy of growth at all costs is becoming a threat to macro-economic stability. Inflation is running at around 25%, the trade balance is deteriorating, the current account and budget have both gone into deficit, and the peso has fallen sharply.
In addition, capital outflows have jumped to around US$3 billion a month, as residents anticipate further currency depreciation (Chart 4).
To protect the peso and central bank reserves, the government has tightened capital controls. All purchases of foreign exchange now need to be audited by the tax agency.
Moreover, hydrocarbon and mining companies have to convert all their export revenues to pesos and bring home all export profits.
Such capital controls may help in the short term, but will be counterproductive in the longer term, as they erode investor confidence and ignore the root causes of the falling peso.
Roger Donnelly, Chief Economist
rdonnelly@efic.gov.au
Dougal Crawford, Senior Economist
dcrawford@efic.gov.au
Ben Ford, Senior Economist
bford@efic.gov.au
The views expressed in World Risk Developments are EFIC's. They do not represent the views of the Australian Government.