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Roger Donnelly, Chief Economist
rdonnelly@efic.gov.au
Benjamin Ford, Senior Economist
bford@efic.gov.au
Dougal Crawford, Senior Economist
dcrawford@efic.gov.au
The views expressed in World Risk Developments are EFIC's. They do not represent the views of the Australian Government.
International: China slowdown overshadows commodity prices
The Chinese economy – particularly investment – is slowing. With the US and EU economies still weak, this slowdown could have a large impact on commodity prices.
Over the past year, the impressive expansion in the Chinese economy has been driven by surging investment, underpinned by fiscal stimulus and easy credit. Investment contributed 92% of GDP growth in 2009. But the limit to which investment can drive the Chinese economy appears now to have been reached.
In recent months signs have emerged of a real estate bubble, overcapacity in some industries, and a bad loan hangover at banks. To counteract these problems, the authorities have lowered credit targets and tightened lending regulation – particularly for loans to local government entities and for real estate. This appears to be having the desired effect. Growth in loans, investment and GDP all slowed through the June quarter (Chart 1). The slowdown continued in July, with industrial output expanding at its lowest rate in 11 months and imports continuing to slow noticeably in year-ended terms.
Commodity markets are watching these developments closely. With the major advanced economies stuck in the doldrums, China has become the incremental consumer of most minerals, such as iron ore, copper and nickel. According to the International Energy Agency, it has also eclipsed the United States as the world’s No. 1 energy user (Chart 2). This differs greatly from a decade ago, when China’s energy consumption was only half that of the United States. Indeed, the IEA forecasts that non-OECD countries will be responsible for all growth in oil demand in 2010 and 2011, with China the key contributor.
Already evidence is coming in that commodity prices may have peaked. The volume of Chinese imports of iron ore, coal and copper are down by at least 10% from March. Meanwhile, spot prices of coking coal and iron ore have slipped below current contract prices.
International: Rising wheat prices more a peak than plateau
The recent spike in world wheat prices is unlikely to be a rerun of the ‘global food crisis’ of 2008.
Russia’s wheat crop has been hit by drought, with production expected to be down by 25-40% from last year. To preserve supplies for home consumption, the Russian government has banned grain and flour exports till the end of the year. It has also asked its customs union partners – Kazakhstan and Belarus – to follow suit.
In response, international wheat prices have surged – on the Chicago Mercantile Exchange one month wheat futures are up by 50% from their June low (Chart 3). Corn and barley prices have also risen strongly. The rising prices have raised fears that the world economy is facing a re-run of the 2008 food price spike.
However, the surge in prices may be short-lived. Russia produces 10% of worldwide wheat, so a 50% cut in production implies only a 5% drop in world supply. Besides, the fall in Russian output is into a market where stocks are plentiful after bumper 2008 and 2009 seasons. The US Department of Agriculture estimates that average worldwide stocks for 2010-11 will be 40% higher than in 2007-08 when prices soared to record levels. Stocks of barley, corn and rice are also at relatively healthy levels.
Nevertheless, there is a risk that the export ban and drop in Russian production leads to panic buying by importers and encourages other exporters whose crops are below average to cap exports. In recent days Ukraine has flagged such a cap.
The higher prices are good news for Australian grain farmers. According to the Australian Bureau of Agricultural and Resource Economics, the forthcoming wheat crop will be a solid 22 million tonnes, up slightly from last year. So farmers may receive both volume and price windfalls. These will add to windfalls miners have already received from metal, ore and energy price rises.
Russia: Privatisation reach could exceed grasp
Re-announced plans to sell off stakes in state-owned enterprises have attracted investor interest, but would-be buyers could be deterred by the prospect of being a co-owner with the Kremlin. Internal critics could also disrupt the process.
Russian Finance Minister Alexei Kudrin has confirmed plans to raise up to US$29 billion through open market sales of stakes in around 10 market-leading majority state-owned companies over the next three years. If fully implemented, this will be the biggest privatisation since the 1990s.
The amount to be raised from asset sales is now more than 12 times larger than the initial estimate when the plan was unveiled last September. The Kremlin scaled up its ambitions as it saw investor appetite come back and the economy improve. Another motivation for the big program is a succession of fiscal deficits that has eaten into fiscal reserve funds built up over several years from high oil and gas prices. Asset sales look to be a relatively painless way of plugging the gap, as opposed to the hard work of budget cutting.
Foreign investors generally welcomed the privatisations when first announced, because they offered the potential to gain stakes in cash generators such as oil pipeline operator Transneft and oil company Rosneft. But that enthusiasm may cool once the reality of being a co-owner with the Kremlin sinks in: the state plans to keep stakes of at least 51%, and at least 75% in Transneft. Given Russia’s institutional weaknesses, reflected in their bottom quartile rankings on World Bank governance indicators – notably rule of law, controlling corruption and political stability – foreign minority investors could well find themselves at a disadvantage in dealing with a co-owner that also sets the rules of the game. In addition, internal critics of privatisation could seek to reshape the pace and scope of the privatisations, either by demanding higher prices or fewer asset sales, or both.
If the asset sale plan falters, the government will still have to plug the fiscal gap by other means. Higher oil prices could come to the rescue, but failing that, the choice will be greater borrowing versus belt tightening, with the odds favouring the first.
Vietnam: Twin deficits prompt Fitch downgrade
On 28 July, Fitch downgraded Vietnam’s long-term foreign currency rating to B+ from BB-, four steps below investment grade. The deterioration in creditworthiness reflects sizeable ‘twin deficits’ – a rarity in Asia – and heightened risk of a banking crisis.
According to Fitch, Vietnam’s fiscal deficit will be equivalent to 7½% of GDP in 2010, while its current account deficit will top 10% of GDP. This leaves the country vulnerable to any worsening in international credit conditions.
The agency also notes rising contingent liabilities stemming from implicit guarantees of the banking sector and state-owned enterprises (SOEs). It has raised its risk estimate of a systemic banking crisis from ‘moderate’ to ‘high’. Rapid loan growth over recent years has seen a deterioration in the quality of bank loan books. Meanwhile, many state-owned enterprises (accounting for 40% of GDP) are making losses. In July, the government was forced to bail out the increasingly unprofitable ship builder Vinashin, which had accumulated US$4 billion in debt.
Concerns over Vietnam’s creditworthiness are reflected in its sovereign bond yields (Chart 4, LHS). Yields on Vietnamese bonds are trading at a significant premium to Indonesian and Philippine bonds. Previously, the risk premia for these two countries were at or above Vietnam’s.
The dong – pegged to the US dollar – is also experiencing sustained downward pressure (Chart 4, RHS). Since 2008, the central bank has devalued the dong by 20% against the US$, but the spot price continues to trade at the bottom of the target band, indicating that the market still views the currency as overvalued.
Sovereign default is unlikely in the near-term. Indeed, absolute yields on government bonds are still low relative to historical levels. The Asian Development Bank and some private sector economists have expressed surprise with the Fitch downgrade, noting that Vietnam’s problems are not new and that recent economic developments have been more positive. Nevertheless, if the authorities continue to focus on headline growth, and ignore the fiscal, banking and SOE problems, the risk of a financial crisis at some point will remain relatively high.
For more information on Vietnam, see the recently published country profile.
Dubai: Companies continue to struggle with debt overhangs
Dubai’s economic outlook continues to be clouded by corporate debt defaults and restructurings – despite recently announced restructurings of two flagship companies, Dubai World and Nakheel. Troubles have recently surfaced in another group – Dubai Holdings.
In May, Dubai World reached agreement with its creditors to restructure US$14.4 billion of debt, at a substantial haircut. Dubai World is the emirate's largest government-related entity and owner of DP World, the world’s third biggest port operator. The deal excluded Dubai World's property subsidiary Nakheel, which presented its own debt restructuring proposal to creditors in July (a response is expected by end-August). The Nakheel deal is more generous than the Dubai World one, with interest rates reportedly set at around 4% above benchmark rates. Nakheel has started making payments to trade creditors, based on a deal concluded in April. It is offering ‘full’ principal repayment of 40% cash and 60% in a tradeable Islamic bond with a 10% yield.
As positive as these developments have been, markets continue to price in a significant risk of further debt difficulties in Dubai (Chart 5). At 460bp above US Treasuries, the sovereign CDS spread is well above the Abu Dhabi spread and the emerging markets average.
Market attention has now turned to Dubai Holdings – owned by the ruler of Dubai – which reportedly has US$15 billion in debt. In May, its private equity arm, Dubai International Capital, secured a three month extension on debt payments. Meanwhile, another subsidiary Dubai Holding Commercial Operation Group (a real estate, hospitality and business parks operator) reported a full-year loss of US$6.4 billion in June and in July got a two-month extension on a US$555 million credit line. The CDS spread on Dubai Holdings is currently around 1000bp.
For more information on the United Arab Emirates, see the recently updated country profile and April World Risk Developments.
West Africa: Promising iron ore pipeline faces challenges
Australian miners are showing renewed interest in developing rich iron ore deposits in West Africa, but political risks and infrastructure challenges will constrain progress.
Six of the world’s largest mining and steel companies, including Rio Tinto and BHP Billiton, have plans to develop substantial mines in various West African countries, a couple of which contain some of the world’s richest untapped deposits of iron ore. The region has long been on the radar of mining investors but project development has been hindered by political risk and financing constraints.
According to a tally by Macquarie Bank, miners are currently working on around 20 iron ore projects in seven West African countries – Gabon, Guinea, Ivory Coast, Liberia, Mauritania, Senegal and Sierra Leone – with a potential total annual production of approximately 400 million tonnes, roughly equal to the combined current output of both major Pilbara producers. The estimated capital costs to develop these projects are similarly large: Phase I development of Rio's Simandou iron ore concession in Guinea will cost US$6 billion; a BHP Billiton project in Liberia US$3 billion; and three projects involving multinational steel concern Arcelor Mittal US$4 billion-plus. At the smaller end of the spectrum, Perth-based company, Sphere Minerals, is currently well advanced in developing its Guelb el Aouj project in partnership with Société Nationale Industrielle et Minière (SNIM), Mauritania’s state-owned iron ore producer. The project has a capital cost of at least US$1.65 billion and the mine could be producing in 2012 (Figure 1). And in Cameroon Perth-based Sundance Resources is building its Mbalam mine at a cost of more than US$3 billion.
Figure 1: Selected West African iron ore projects and capex estimates
Sources: EFIC, Financial Times, Bloomberg, company websites
The appeal of West African iron ore is its high quality – high iron content and low impurities – particularly in Guinea, which should enable it to earn a premium on the international market. Macquarie reckons that the lowest-cost West African projects come in at around the 65th percentile of the iron ore cost curve on a delivered-China basis – attractive considering that ore from Vale’s Carajas system in Brazil and from the Pilbara (Rio and BHP) dominates below that.
Still, despite the region’s potential, development has been hindered by political risks, notably long-standing civil wars, unstable regimes and inhospitable investment climates. Even now that many of these conflicts have been resolved, most West African states remain risky investment destinations. Take Guinea, site of the richest untapped iron ore deposits: the two frontrunners in an upcoming presidential election have both said they will review mining contracts established by the current military junta. Rio is also at loggerheads with the junta for taking away half of its Simandou concession. Two other iron ore-rich countries, Liberia and Sierra Leone, are making fitful recoveries from devastating civil wars and are struggling to deliver even rudimentary services to their citizens let alone create the right policy mix for technically complex mining operations.
Project development has also been constrained by the need to build transport infrastructure from the ground up. Rio’s Simandou concession, for example, requires the construction of a 650 km rail line and associated port. A lack of deepwater ports is a broader problem. For example, Port Buchanan in Liberia can only accommodate Panamax ore ships rather than larger over Panamax ships. This infrastructure deficit adds to both the capital cost of mine development and transport costs.
Because of political risk and infrastructure deficits, only some of the 20-plus projects on the drawing boards will progress to full production. Likely candidates to make the grade are those that can harness ‘cluster’ benefits, notably the sharing of infrastructure. Companies may well need to bring in a cashed-up partner to provide start-up capital or infrastructure expertise. Two recent tie-ups with Chinese companies suggest potential for this kind of cooperation exists: China’s state-owned aluminium company Chinalco will pay Rio US$1.35 billion in return for 47% of its Simandou concession in Guinea; and AIM-listed explorer African Minerals has signed agreements with China Railways Materials Commercial Corp and Shandong Iron and Steel, to develop the Tonkolili iron ore deposit in Sierra Leone.
Kenya: New constitution diffuses some tensions, increases others
Though a new constitution should in theory help to diffuse ethnic tensions, it has angered the Kalenjin tribe in the Rift Valley in particular. This could provoke further violence at the 2012 election.
The new constitution was approved by a 70% majority in a referendum on 4 August. Fears that it would be marred by violence of the sort that followed a disputed December 2007 general election, in which 1,500 people were killed and 300,000 made homeless, proved baseless. Nevertheless, security forces had to be sent to hotspots where tribes opposed to the constitution's land redistribution reforms had gathered. There were also were reports of ‘migrants’ being intimidated in the Rift Valley, scene of much of the violence in 2007.
The main features of the new constitution are: greater checks on presidential powers, a clearer separation of powers between the executive and legislature, devolution of powers to county governments, a greater emphasis on transparency and accountability, and an increase in civil liberties.
Both President Mwai Kibaki and Prime Minister Raila Odinga campaigned together for a ‘yes’ vote. Though rivals during the 2007 election, they joined a power-sharing government after the election to halt the violence. Opposing them were two groups: one led by Higher Education Minister William Ruto and former president Daniel arap Moi; and the church. Ruto was one of the ringleaders of the 2007 violence, according to the state-funded Kenya National Commission on Human Rights. On the hustings he claimed that the new county administrations did not go far enough to devolve power, and that the new constitution would threaten the interests of smallholder farmers. However, the real grounds for his opposition are reportedly that the new constitutionwould break up his power base in the Rift Valley. The church, with support from American evangelical groups, opposed the constitution on different grounds: it denounced a provision that, while banning abortion in general, allows it to save a mother's life; plus another provision to recognise the country's Muslim courts.
The only province to oppose the constitution was the Rift Valley, where Ruto’s Kalenjin tribe voted heavily against it.
The new constitution should help to diffuse tensions among Kenya’s 42 ethnic groups – tensions that have so bedevilled the country since its independence in 1963. Its financial devolution provisions hold out the promise of narrowing inter-tribal wealth and income inequalities, while a provision to set up a commission on land rights and land ownership will tackle another source of conflict. In addition, the adoption of the constitution will help to combat radicalisation of the country's Muslims.
Still, according to many analysts, the defeat of Ruto and his fellow Kalenjins could provoke further violence at the 2012 election.