February 2010 

 February 2010 



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Roger Donnelly, Chief Economist

Dougal Crawford, Senior Economist

The views expressed in World Risk Developments are EFIC's. They do not represent the views of the Australian Government.


International: LUV is in the air

World GDP forecasts for 2010 and 2011 continue to be upgraded, though concerns remain about the sluggishness of private demand.  A notable feature of the current recovery is the emergence of wide growth gaps between and within advanced and emerging economies.

The latest prominent forecaster to revise up its numbers is the IMF.  It is now forecasting world GDP growth to be 3.9% in 2010, up ¾ of a percentage point from its call in October.  For 2011, the Fund now expects a 4.3% expansion, 0.1 of a percentage point higher than forecast in October (see chart). (This is for GDP calculated in purchasing power parity terms, which gives greater weight to fast-growing emerging economies and hence boosts the overall growth numbers.  At market exchange rates, the IMF expects growth of 3% in 2010 and 3.4% in 2011.)

WRD February 2010 Chart 1

A striking aspect of the Fund’s forecast is its composition, with the eurozone lagging the US, which in turn lags emerging economies.  The eurozone is expected to grow at only 1% in 2010 and 1.6% in 2011.  The corresponding numbers for the US are 2.7% and 2.4%, and for emerging economies 6% and 6.3%.

Sir Martin Sorrell, CEO of advertising firm WPP, has cleverly called this growth pattern LUV – an L-shaped recovery for Europe, a U-shaped recovery for the US, and a V-shaped recovery for the BRICs and Next 11.

The recovery implied by the Fund's forecast for advanced economies is a modest one given the large drop in output in 2009 and the ample spare capacity this has created.  If the forecast eventuates, GDP in advanced economies will remain below its pre-crisis level until late 2011 (see chart, green line).

Though overall growth in emerging economies is expected to be much faster, growth disparities are apparent here too.  Emerging Asia is expected to lead the revival, while ‘Emerging Europe’ and the CIS straggle.  The rebound in resource prices – if sustained – will support growth in the Middle East and Sub-Saharan Africa.

Not only does it look like the world economy will take a while to climb out of its hole; the climb-back is also heavily ‘policy-driven’, to use the IMF's phrase. ‘There are few indications that autonomous (not policy-induced) private demand is taking hold.’ 

So while there is good news in the current forecast – a quite vigorous overall recovery – there is also bad – many economies performing below potential and the risk of ‘double-dip’ recessions as policy stimulus is withdrawn.

Greece: Default concerns escalate

While the IMF has been revising up its world growth forecasts, concerns about Greek sovereign risk have been mounting.  There is a tension here: difficulties by Athens in meeting its financing needs could set off another round of global risk aversion, which could in turn act as a drag on world growth.

The difficulties of Greece are manifold.  Among these are, first, disorderly public finances with a very large budget deficit and public debt. As a percentage of GDP, the budget deficit was reportedly 12.7% in 2009 (many believe it is higher), while the gross public debt was more than 100% (see chart below).  Together this deficit and debt mean that the government has a mammoth gross financing need: reportedly around 60 billion euro in 2010, half of which falls in the June quarter.  Second, there is a ‘twin deficit’ problem: not just a large fiscal deficit, but also a yawning external current account deficit, equivalent to around 9% of GDP in 2009.  This means that the government and the country are reliant upon the ‘kindness of foreign strangers' for their financing, not a comfortable place to be when markets are jumpy. Third, there is unpromising demography with rapid ageing and an imminent population decline: hindering the ability of the government to make structural budget improvements. Fourth, the economy has a competitiveness problem with firms  pricing themselves out of international markets due to outsized wage and price increases over the past decade.  Fifth, membership of the eurozone means Greece can't devalue to restore its competitiveness.  Sixth, there is concern that the country won't be able to mount the sort of adjustment that will bring it back to living within its means.  A widely-reported story of tax collectors and customs officials going on strike over a government deficit-cutting plan exemplifies this worry. 

WRD February 2010 Chart 2

A sharp sell-off of Greek bonds immediately after an initially successful 8 billion euro bond sale in late January has dealt a large blow to market sentiment and is increasing the chances that future debt auctions will fail and Athens will be forced to seek finance from fellow eurozone states or the IMF.  Such help will probably be forthcoming, despite the statements of some EU politicians and officials recently that there will be no bailout.  This is probably a gambit to put pressure on Athens to get serious about budget balancing.  In the final analysis, other eurozone governments would probably baulk at seeing Greece default, because that would mean, first, further large losses for European banks with Greek exposures, and second, contagion to other eurozone governments with fiscal difficulties – Ireland, Spain, Italy, Portugal.

Market disillusionment has already spread to those other countries.  Five-year CDS spreads for Portugal had risen to 230 basis points and for Spain and Ireland to 170 points each versus Greece at 430 basis points.  Fortunately these countries do not have fiscal challenges as serious as Greece’s.  Their debt/GDP ratios are much lower (see chart below).   And while their financing needs are large, they have more credible fiscal consolidation plans.  Greek debt is currently rated BBB+ by ratings agency Standard & Poor's, just three notches above speculative grade, whereas Ireland is AA, Spain AA+ and Portugal A+.

WRD February 2010 Chart 3

So a failure by Athens to meet its financing needs from the private market would be unlikely to result in a default.  But it would upset markets worldwide, leading to a general tightening of credit and weakening of animal spirits.  That is the broader significance of Greece.

Vietnam: Over-stimulated economy

Substantial policy stimulus has helped Vietnam avoid the worst of the global financial crisis, with GDP expanding by around 5% in 2009.  But this has widened macroeconomic imbalances that were already considerable going into the crisis – twin fiscal and current account deficits, high inflation, asset price bubbles and a weak banking sector.  

A large fiscal package, including an interest subsidy of 4 percentage points on loans to small and mid-sized firms, tax cuts for individuals and businesses, and spending on a range of infrastructure projects, has underpinned a domestic demand-led economic recovery.  But there is growing evidence that the authorities may have been too forceful.  The fiscal deficit doubled to 10% of GDP in 2009, while domestic credit has surged, reaching 36% y/y in November.  This credit surge has helped reignite inflation and asset bubbles and weakened the balance of payments, with the trade deficit topping US$12 billion in 2009 (see chart).

WRD February 2010 Chart 4

The government should be able to finance its deficit in the short-term.  The greater danger is failure to bring inflation and the twin deficits under control.  That could push local and foreign investors, concerned about their eroding wealth and the weakening currency, to switch into foreign assets and gold.  Dollarisation is already high in Vietnam, at around 20% of deposits. 

The dong is already under pressure.  In November, the central bank devalued the dong by 5% against the US dollar and tightened the daily trading band to 3% from 5% (see chart). Further depreciation is likely, with the currency continuing to trade at the bottom of its target band (see green line).  The central bank has reportedly run down its foreign exchange reserves to less than three months' import cover through defence of the currency. 

In late January Vietnam tapped international bond markets for US$1 billion.  However, the bonds had to be priced at a 3.3 percentage point premium over US Treasuries, noticeably higher than the 2.3 and 1.8 percentage point premiums paid by Indonesia and the Philippines earlier in the month.  Note that despite this larger premium, S&P rates Vietnam BB with a negative outlook, one notch higher than both Indonesia and the Philippines.

WRD February 2010 Chart 5

Indonesia: Almost safe for widows and orphans?

Not all economies are succumbing to the international financial and economic storms.  Recently ratings agency Fitch upgraded Indonesia’s long-term foreign and local currency debt rating from BB to BB+, just one notch below investment grade.  Still, a large fuel subsidy program keeps the economy vulnerable to oil price jumps.

In making its upgrades, Fitch highlighted Indonesia’s resilience to the global financial crisis, falling public debt ratios and strengthening balance of payments. Indonesia has certainly been one of the better-performing economies in 2009.  Output grew by around 4½% and is forecast to accelerate to around 6% in 2010.  Meanwhile, public debt has continued to shrink, reaching 30% of GDP in 2009.  The balance of payments has also strengthened after experiencing some wobbles at the height of the crisis in late 2008 (see chart). After a brief descent into deficit, the current account is now back to solid surplus following a drop in imports and recovery of exports.  Meanwhile, foreign exchange reserves reached US$64 billion in December.  Fitch forecasts Indonesia’s 2010 gross external financing need to be only 43% of foreign exchange reserves, well below the average of similar rated countries. 

WRD February 2010 Chart 6

With its fundamentals improving and its asset yields high, the economy has been a magnet for capital inflow on a renewed hunt for yield.  Taking advantage of this yield hunger, the government successfully tapped the international bond market for US$2 billion in mid-January, completing half of its planned raisings for 2010.  The spread on Indonesia’s sovereign bonds compared to US Treasuries is now around 280bp, down from over 1000bp in October 2008. The private sector is also reportedly having no problems in rolling over existing or raising new external debt. 

Oil prices remain a risk. The government has stepped back from a previous plan to phase out fuel subsidies so that domestic fuel prices converge on world prices.  While this will help contain inflation and protect household incomes, it leaves the budget exposed to oil price increases.  In 2005, a rise in the oil price forced the government to hike administered fuel prices by 155%, leading to a sharp jump in inflation and domestic unrest.  In contrast, clamps on fuel and electricity price rises through the 2008 oil price spike raised the cost of Jakarta's subsidies program to a considerable 5.6% of GDP.

Turkey: Another comparative success story

Despite its fiscal and external vulnerabilities, Turkey is another ‘Next 11’ economy that has weathered the global financial crisis well.  Thanks to its resilience, Fitch upgraded the country by two notches to BB+ in December – just one notch below investment grade.  Moody’s followed suit in early 2010, upgrading its rating to Ba2. While investment grade status is on the horizon, more needs to be done to return government finances to a sustainable footing.

Investors have certainly become more confident about Turkey’s prospects.  This enabled the government in January 2010 to conduct a reportedly heavily oversubscribed US$2 billion Eurobond issue. Meanwhile, the spread on Turkish sovereign bonds has dropped from 500bp to 250bp over the past year – 100bp below the emerging market average and similar to investment grade emerging market sovereigns (see chart).  In addition, the lira has stabilised and begun to strengthen, after dropping by 45% between October 2008 and March 2009.

WRD February 2010 Chart 7

For all these pluses, the country still has significant hurdles to overcome before reaching investment grade.

  • Slump legacy.  GDP contracted by a painful 6% in 2009, with the unemployment rate peaking at 16% in February 2009 and still at 13% in October 2009.  The world recovery, renewed capital inflow and inventory replenishment will result in growth resuming in 2010.  But at a forecast 3-4%, it will be considerably weaker than the pre-crisis average of 7% a year. 
  • Fiscal consolidation.  The downturn has been a setback to fiscal consolidation, under which public debt dropped from 74% of GDP in 2002 to 40% in 2008.  In 2009, the budget deficit climbed to around 6% of GDP.  If quickly reined in, this deficit won't do lasting damage.  The government has announced a plan which projects debt peaking at 50% of GDP in 2010, before resuming its downward trend.  Markets will now focus on the execution of the plan.  An ‘external anchor’ in the form of an IMF program or a ‘fiscal rule’ (proposed but not yet fleshed out) would buoy confidence, particularly as general elections approach in 2011.  Then again, a hike in pre-election spending would undermine confidence.
  • Financing risks.  Near-term financing risk has dropped thanks to a rebound in global risk appetite and a sharp narrowing in the current account deficit from 6% of GDP in 2008 to 2% in 2009.  Nevertheless, as growth resumes the current account deficit will widen.  This deficit together with ongoing debt refinancing needs (notably from the private sector debt which accounts for 65% of total external debt) means that Turkey’s balance of payments will remain exposed to swings in world capital markets. 

Needless to say, financing difficulties in neighbouring Greece would not be helpful to Turkish borrowers – public or private.

Sri Lanka: Election question-marks

Sri Lanka's first peacetime election in more than two decades has been marred by allegations of electoral irregularities and confrontational tactics.

In a 26 January presidential election, President Mahinda Rajapakse won a second six-year term.  Against expectations of a close contest, he won by a large margin over his main rival, the former military commander General Sarath Fonseka – with 58% of the vote to the general’s 40% on a voter turnout of more than 70%.  His main support was in Sinhalese-dominated areas, where he won with votes of up to 70%.  He trailed Fonseka in the north, the east, the central hills and Colombo, where Tamils and Muslims live in large numbers.

Though the result appears to be clear-cut, there are concerns over how the president achieved it. 

During the election campaign, he attacked the opposition, alleging they were in a plot with Tamil separatists and ‘western imperialists’ to divide the country.  Meanwhile, national TV carried documentaries about Hitler and Idi Amin next to warnings of the dangers of soldiers stepping into politics.  There have been widespread complaints from internally displaced civilians about transport to polling stations, voter registration and issuance of ID cards.

After the polls closed, soldiers established a heavy presence outside the hotel in central Colombo where Fonseka was staying.  The government alleged that Fonseka was plotting a military coup.  Post-election reprisals have also been reported against journalists, opposition supporters and soldiers. 

The president has since ordered a major reshuffle of senior military ranks and arrested more than 30 officers – including a brigadier – suspected of being close to Fonseka

On 8 February, military police arrested Fonseka.  Though the details are scant, he will reportedly be court martialled on grounds of working with the political opposition while still in uniform. Amnesty International has expressed concern at the arrest, noting that it followed Fonseka's statement that he would testify in international war crimes investigations. These would reportedly be likely to investigate Rajapakse's close advisers and relatives. The defence secretary, for instance, is Gotabhaya Rajapakse – the president's younger brother.

On 9 February the government announced that it would dissolve parliament.  It has set parliamentary elections for 8 April.

The consequences of the presidential election will now need to be watched in four areas.

Parliament.  The government will seek to follow through on the president's victory with a strong parliamentary victory.  If it can gain a two-thirds majority in parliamentary elections, it will be able to amend the country's constitution to remove the two-term limit on presidents.  For its part, the opposition will strive to gain a parliamentary majority by capitalising on disillusionment with the conduct of the presidential election.  The Sri Lankan president has considerable powers, but can only fully exercise them if he enjoys the backing of a parliamentary majority. A hostile parliament can undermine the presidency through its control of public finances. In 2001, for instance, former president Chandrika Kumaratunga lost her parliamentary majority and saw power in key areas swing to the prime minister.

Economy.  Thanks to the ending of the civil war and world economic recovery, the economic outlook was brightening before the election.  GDP growth was expected to double to 6% in 2010, as exports and consumer and business confidence both turned up, north-south trade resumed, reconstruction got underway, and overseas Tamils ramped up remittances.  To see the sort of peace and unification dividend that can be received, look at the temporary ceasefire of 2002.  In its aftermath, the north of the island registered GDP growth of 10-12% in 2002, and longer term the ceasefire is estimated to have added around ½ - 1 percentage point to annual growth. Even during the civil war, Sri Lanka grew by 5% a year on average. 

The victory of Rajapakse will ensure some political and policy continuity, which will reduce uncertainty.  Still, concerns remain about how he will rein in the budget deficit and control inflation.  Additional concerns revolve around the degree of acceptance of the election result.  The international financial press is reporting disappointment by investors who had hoped that the election –  following the end of the civil war – would reduce uncertainty and increase stability.

Political protest.  Following Fonseka's arrest, thousands of government and opposition supporters clashed in Colombo on 10 February. One opposition party, the Janatha Vimukthi Peramuna, has strong links to the trade unions and student movement.  It could now organise street protests, according to some analysts. 

Foreign relations.  Even before the elections, the international community had concerns with human rights issues in Sri Lanka.  The European Union had reportedly decided to suspend trade benefits and tariff exemptions to Sri Lanka under the Generalised System of Preferences Plus (GSP+) Program.  European finance ministers are expected to endorse this decision on 16 February, with the suspension to come into effect six months afterwards.  In October 2009, the US State Department released a report to Congress on possible human rights violations allegedly committed by Sri Lanka's army and the Tamil Tigers during the final stages of the conflict.  Then on 7 January the UN concluded that a UK Channel 4 video of Sri Lankan soldiers carrying out extrajudicial executions was authentic and called for a response from Colombo, including the establishment of an independent war crimes enquiry.

Partly in response to these criticisms,  the government had been seeking to reduce its dependence on western trade and aid partners by fostering relations with Russia, China, Iran and other non-Western countries.  Some analysts claim that this tilt will increase now that Rajapakse has been re-elected.  Others are sceptical, noting that it is reaching its limits.

It is early days and premature to be making overly-confident predictions about how the election will affect the economic outlook, the ethnic divide and so forth.  Nevertheless, it can be confidently said that the country still has a long way to go to achieve lasting stability and reconciliation.