EFIC World Risk Developments - October 2011 
 

 EFIC World Risk Developments - October 2011 

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Comprehensive eurozone debt plan in the works

European governments are reportedly considering plans to recapitalise the European banking system as a precursor to further writing down Greek public debt.

The European Banking Authority concluded a two-day meeting over 5-6 October in which it stress-tested European banks with a write-down of their holdings of peripheral euro-area public debt. It also discussed ways to recapitalise banks, forcibly if need be, to eliminate capital shortfalls across the European banking system reported to be as much as 200 billion euros (US$276 billion). German Chancellor Angela Merkel and French President Nicholas Sarkozy also discussed recapitalisation on the weekend of 8-9 October ahead of an EU summit this weekend and a G20 meeting on November 3-4.

There are reportedly two issues under discussion. One is whether recapitalisation should be undertaken by national governments, as urged by Germany, Finland and Holland, or by the European Financial Stability Facility (EFSF), France's preference. France's state holding agency is reportedly working on a plan to take stakes in two or three unnamed banks; French banks have the largest exposure to Greek private and public debt. The second issue is the extent of the recap. There are reports that banks will be directed to raise their core Tier 1 capital quickly to 9% and if they can't raise the extra capital themselves they will be forced to accept state capital along the lines of the 2008 American TARP.

The idea behind the recap is to make the banks strong enough to withstand another writedown of Greek public debt beyond the 21% 'haircut' already administered, and possibly writedowns of other distressed 'peripheral' debt as well. The risk, however, is that the banks will try to shrink their way to a higher capital ratio by calling in loans rather than raising more private capital or accepting state capital. Such a credit tightening would be an extra drag on an already weak euro area economy.

The market reaction

European bank shares have recently fallen sharply on investor fears that bank capital is insufficient to withstand a Greek default or ‘mark to market’ of the banks’ other holdings of peripheral public debt. The current break-up of the Franco-Belgian bank Dexia is reinforcing the fears. Though Dexia had a capital ratio well above the Basel minimum capital benchmark, its financial strength was compromised by a reliance on wholesale funding markets, substantial exposures to peripheral euro area governments and a retail operation facing a tough consumer environment.

Ratings agencies have also been busy venting their worries about banks. Moody's earlier this month downgraded nine Portuguese banks due to exposure to Portuguese government debt and downgraded 12 British banks following a 'review of the systemic support functions from the UK government for these institutions'. Standard & Poor's (S&P) and Fitch, meanwhile, have downgraded the leading banks in Spain. S&P cut its ratings of 10 banks, including Santander and BBVA, while Fitch lowered its ratings for six banks, including BBVA. Both agencies highlighted deteriorating funding conditions for Spanish banks because of deepening debt problems in the euro area. Late last week, S&P also downgraded BNP Paribas’s credit rating one notch to AA- and reaffirmed its lower A+ rating on France’s next four largest banks: BPCE, Credit Agricole, Caisse Centrale du Credit Mutuel, Banque Federative du Mutuel, and Societe Generale.

In a related development, Moody's on October 4 cut Italy's sovereign debt rating from Aa2 to A2, with a negative outlook. This followed a similar downgrade by S&P in September from A+ to A, also with a negative outlook. Both downgrades reflect concerns about rising solvency and liquidity risks – since August, Italy has been dependent on bond purchases by the European Central Bank to keep yields manageable.

The downgrades of Italy are putting additional strain on Italian, French and German banks heavily exposed to Italian debt.

IMF growth downgrade

The IMF’s latest World Economic Outlook foresees ‘slowing growth and rising risks’.

The outlook released mid-September slashes the Fund’s annual growth forecast for the North Atlantic to just 1½-2% for both 2011 and 2012 (Chart 1).  This is very close to ‘stall speed’ – a pace of growth so low that the economy is liable to stall in response to any setback. 

Chart 1: World GDP growth forecasts

The Fund apparently thinks Asia will be able to withstand the North Atlantic slowdown, because it has left its forecasts for Asia (ex-Japan) largely unchanged (Chart 1, RHS). This is important for Australia, because over half of its exports go to this region.  The IMF sees Australia growing by 3¼% in 2012.

The Fund did, however, warn that the Asian outlook could worsen if the North Atlantic 'double-dips' into recession again. Its modelling suggests a recession of 1-2% in the North Atlantic could cut Asian GDP growth by a third. 

For details on how a North Atlantic recession could hurt Asia, and thence Australia, see the following article.

Sino-US currency dispute

Deteriorating conditions in the world economy are again breeding American resentment against China's intervention in the currency market to hold down the renminbi.

Beijing warned on October 4 that implementation of an American law to impose stiff tariffs on goods from countries engaging in currency undervaluation would amount to a ‘trade war’. The Currency Exchange Rate Oversight Reform Act has now passed the US Senate.  It calls for imposition of countervailing duties on goods from countries found by the Commerce Department to be subsidising their companies through an undervalued currency.

The bill applies to all American trading partners, but its promoters have indicated their chief target is China. In recent years, American legislators have tried unsuccessfully on several occasions to 'punish' China for alleged currency manipulation. The present bill looks as if it will also founder, because it still has to secure passage in the House of Representatives and avoid a presidential veto, both of which are unlikely.

Falling commodity prices

A$ commodity prices have largely managed to defy the recent international price correction thanks to two things – iron ore and coal exceptionalism plus a depreciating A$. A Chinese slowdown is the biggest threat to Australian commodity exports.

International commodity prices have been dropping recently in response to concerns about the world economic outlook.  Since end-July, copper has slumped by 25% to US$7200/t.  Brent oil is currently trading around US$107/barrel, down from US$118/barrel mid-year.

Steep as those price falls have been, they need to be kept in perspective.  Prices are still very high on a long run and even cyclical view (Chart 2).

Chart 2: Commodity prices

Moreover, prices for Australia’s key commodity exports – iron ore and coal – have been resilient.  At this stage, the markets for these commodities remain tight, helped by supply disruptions earlier in the year, and continued strong Chinese demand.  Coal and iron ore account for about one-third of total Australia exports. 

The fall in the A$ has also partly offset the fall in US$ commodity prices.  The A$ is down by about 10% since end-July. 

Apart from problems in the North Atlantic, the key downside risk to commodity prices is weakening Chinese demand.  After all, China has been the source of nearly all incremental demand over the past decade (Chart 3).

Chart 3: Demand for commodities

Yet that demand could be quite fragile, because it is underpinned by an unhealthy reliance on fixed asset investment, including in real estate. There are reports that the real estate market is now turning.  Some smaller property developers are struggling to obtain loans now that the People's Bank is tightening credit.  Land sales have also slowed sharply.  Real estate accounts for 25% of total investment so any correction could have a material impact on China’s demand for commodities.  Then again, a government plan to build 36 million low cost housing units by 2015 may provide some offset.

Sino-Burmese dam dispute

Burma's suspension of a controversial hydroelectric dam venture is a bid to win over both the Burmese public and the international community, but it risks alienating its most important ally, Beijing. The move also highlights the difficulties that Chinese firms face as a result of their willingness to accept political risk.

Burma's president suspended on 30 September construction of the US$3.6 billion Myitsone hydroelectric dam until at least 2015 ‘because it is against the will of the people’.  The construction was being undertaken by a joint venture between Chinese and Burmese companies and was due for completion in 2019. The dam on Burma's longest river, the Irrawaddy, would have been one of the largest in the world and would have sold the bulk of its electricity to China. The reservoir it created would have displaced ethnic communities in Kachin state, where an armed insurgency has arisen partly to oppose the dam. Activists have also moved to oppose the project and opposition leader Aung Sang Suu Kyi has lent her support.

China has taken advantage of Western sanctions to become Burma's largest foreign investor. But popular anti-Chinese sentiment is growing and the new civilian government which took over from the military junta in the March is reportedly seeking to introduce political reforms in a bid to persuade other countries to lift, or at least ease, trade and investment sanctions.  Apart from being more responsive to public opinion on issues like the dam, it has also over the past week released hundreds of prisoners, including several political dissidents.

Investors await next move from Zambia’s new president

Michael Sata has been ruffling investor feathers but it remains to be seen how far his actions will match his words.

Sata, a veteran politician who styles himself ‘King Cobra’ and is known for populist statements, easily won Zambia’s presidential election held in late September, defeating incumbent Rupiah Banda, who had held the office since 2008.

While EU poll observers criticised misuse of state resources by Banda’s party, the MMD, the election itself was fairly peaceful. More importantly, the handover from Banda to Sata appears to have been relatively smooth. This is no mean achievement – many were worried that Banda’s party, which had ruled Zambia for the last 20 years, would try to hang onto power at any cost. 

In the early stages of his campaign, Sata criticised Chinese-owned mines for ‘slavelike’ working conditions and argued that all foreign mining firms should be paying higher taxes and royalties, and hiring more Zambians. But in the final weeks of the campaign, he changed direction, asking mining companies to reinvest more of their profits in Zambia and observe the country’s labour laws.

Since taking office, Sata has done several things to unnerve investors – sacking the central bank governor, replacing the head of the anticorruption agency and temporarily halting – then lifting – copper export permits amid allegations that foreign firms are undertaking unfair transfer pricing and otherwise underreporting income. Meanwhile, the new mines minister Wylbur Simuusa has said the government might seek a stake of ‘at least’ 35% in all projects.

There is broad agreement, including by the IMF, that in the period when copper prices were rising sharply, the government benefited little by way of revenue because fiscal stability agreements locked in what proved to be generous terms for investors. So it is little surprise that Sata may wish to revisit the terms.  Then again, the recent decline in copper prices will restrict his room to move. In addition, the move against permits suggests his focus may be more upon increasing compliance with existing laws than in changing those laws.

A lot is at stake, because, according to the Chamber of Mines, foreign copper miners plan to double production to 1.5 million tonnes a year by 2016, with an expected investment of around US$5 billion.

Mongolian government backs off Oyu Tolgoi, for now

The government has stepped back from its demand for a 50% stake in Mongolia's massive Oyu Tolgoi copper/gold mine. 

It made a recent formal demand to increase its share of Oyu Tolgoi from the current 34% to 50%. The deposit is being developed by Rio Tinto in conjunction with Canadian miner Ivanhoe Mines.

In a joint statement released on 6 October, the Mongolian government, Rio Tinto and Ivanhoe Mines ‘reaffirmed their continued support' for the 2009 Oyu Tolgoi Investment Agreement’. In a separate statement, the government reaffirmed that the investment agreement was ‘signed in full compliance with all laws and regulations of Mongolia’.

The release of the statements ended two fairly tense weeks for investors, who were beginning to question Mongolia’s reputation as an investor-friendly destination for mining capital. The government’s push to increase its share of Oyu Tolgoi also seemed to confirm broader investor worries about moves by governments in a variety of countries to gain a greater share of the windfall profits flowing from strong commodity prices.

Many suspect that the government’s demand to amend the investment agreement was designed to appeased a cross-party group of 20 lawmakers who petitioned the prime minister in early September to revise the accord. The government will need the support of this group after parlimentary elections to be held next June.

Mongolia's mining boom has been accompanied by a surge in FDI – inflows doubled as a share of GDP between 2009 and 2010 and are likely to have jumped again in 2011, as the development of Oyu Tolgoi gathered pace (Chart 4).

Chart 4: Mongolia FDI and copper price

Once fully operational, Oyu Tolgoi will be one of the world’s biggest new copper mines with an estimated resource of approximately 81 billion pounds of copper (and 46 million ounces of gold). The cost to develop the mine is corresponingly large – the joint venture partners have already spent an estimated US$2.6 billion on developing the mine and Rio Tinto expects that capex for Phase 1 will be around US$6 billion.

In this context, the government is legitimately focussed on securing the best deal possible for Mongolians. However, the challenge will be to ensure that this does not deter companies from investing.

Egypt’s balance of payments feels the strain

Egypt’s economy and balance of payments has been hit hard by the continuing political uncertainty.  With parliamentary elections delayed to end-November and speculation that presidential elections will not occur until late 2012 (or even 2013), assistance from Egypt’s multilateral and bilateral partners may be needed to avoid a balance of payments crisis. 

In the first half of 2011, the balance of payments posted a deficit of 10% of GDP (Chart 5).  This chiefly reflected a surge in capital outflows in response to the political turmoil and increasingly uncertain investment climate.  Since the start of the year, foreign investors have sold approximately US$6 billion in Treasury bills and direct investment inflows have slowed to a trickle.

Chart 5: Egypt's large external imbalance

To offset the balance of payments deficit, the central bank has been running down reserves rather than allowing a sharp fall in the pound (Chart 6).  This has helped ensure internal economic stability, but it cannot go on. Official figures suggest that reserves have dropped a third since December, to US$19 billion at end-September 2011. 

Chart 6: Egypt's reserves and currency

The lack of private capital has also meant that the government has become totally reliant on domestic banks to fill its own financing gap (the fiscal deficit is expected to be 8-10% of GDP in 2011). But this is becoming expensive and Egyptian pound liquidity is becoming stretched.  In the September quarter, the central bank cancelled three debt auctions, due to high yields – 3-month Treasury yields are currently around 13%.  

With private capital – foreign and domestic – unlikely to pick up until after elections reports suggest that the interim government may again approach the IMF for financing. In June, they cancelled a US$3.2 billion IMF package (and US$2 billion World Bank package), reportedly because they did not want to saddle the incoming government with a large debt load.  The government has also been in discussions with the UAE and Saudi Arabia for financing worth up to US$5 billion-7 billion. Failure to secure external assistance raises the prospect of a balance of payments crisis at some point, particularly in the event of any further political shocks.

Sri Lankan IMF loan stalls

Discussions with the IMF on Sri Lanka’s next loan tranche have stalled. Against Fund advice, the central bank has been using reserves to defend the rupee in the face of a slowdown in net capital inflows and a widening trade deficit. 

The central bank is arguing that a depreciation is not needed because the pressure on the currency is temporary, with capital inflows about to pick up.  Moreover, the level of reserves is double the initial target under the IMF program – Sri Lanka had US$8 billion of reserves at end-August – so it has the ability to defend the currency in the interim.

Still, if the external imbalance persists (as the IMF believes it will) the central bank will at some point have to raise interest rates (to attract capital inflow and slow the economy), or allow the currency to depreciate (to maintain external stability and reserves), or both.  Over the year to July 2011, the trade deficit reached US$7 billion, a sizeable 13% of GDP and the largest on record (Chart 7).

Chart 7: Sri Lanka's growing trade deficit

The risk is that the depreciation required exceeds what the government considers politically acceptable.  The IMF loan came into existence only because the government ran down its reserves to defend the rupee during the global financial crisis.

Ratings agency Fitch rates Sri Lanka’s foreign currency debt BB-. Standard and Poor’s and Moody’s rate the debt slightly lower, at B+ and B1 respectively, but in July both indicated upgrades were on the horizon.  The yield on Sri Lanka’s US$ bonds is currently 430bp above US treasuries, which is up from 300bp at end-July, but broadly in line with the emerging market average.  
 

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.