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World Risk Developments - February 2011 (Size 2.5Mb)
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International: Strong growth despite sluggish Atlantic economies
The IMF has raised its forecast for world economic growth in 2011 despite the sluggish recovery in advanced economies. Dynamic emerging economies now have sufficient weight to buoy overall global growth.
In the January update of its world economic outlook, the IMF predicts world growth of 4½% in both 2011 and 2012. If realised, such a forecast would imply three consecutive years of above-trend growth over 2010-12.
The Fund expects growth to vary significantly between regions (Chart 1). Emerging markets are expected to power ahead, growing by 6½% this year and next, and accounting for two-thirds of global growth. The advanced economies are forecast to post much softer growth of 2½% a year. After the deep slump they experienced in 2009, such growth will be insufficient to restore them to pre-crisis rates of unemployment, much less full employment.
The Fund sees three risks to the recovery: a eurozone financial crisis (see below), emerging world overheating, and eroding fiscal solvency in key advanced economies.
International: Food prices hit new high
World food prices have reached record highs. For many developing economies this will mean higher inflation and increased risk of balance of payments problems.
Prices have surged by 40% since mid-2010 and are now above mid-2008 peaks (Chart 2). The rise in prices has been attributed to poor harvests (particularly for wheat, sugar, corn and soybeans) compounded by export bans and hoarding. However, the Reserve Bank of Australia notes that rapidly growing demand from fast growing emerging markets is also playing a part, with strong growth in grain consumption coming from ‘BRIC’ countries and Indonesia.
Interestingly, rice, the staple for much of Asia and Africa, has lagged behind that of food more generally; its price has not yet returned to its 2008 peak.
The economies most vulnerable to higher food prices are net food importers where food is a large share of household spending. There, rising food prices can result in severe hardship, fiscal strains (because of subsidies) and balance of payments pressures. Using the 2008 price spike as a guide, Normura has listed the economies that are especially vulnerable. Countries from North Africa and South Asia stand out in this listing.
Food price spikes also increase the risk of discontent and civil unrest. Rising food prices were one trigger for the recent upheavals in Tunisia and Egypt. They were also behind 2008 protests in Latin America, Asia and Sub-Saharan Africa.
Egypt: Unrest delivers severe economic setback
The uprising has pushed the economy into recession and increased the strains on an already over-stretched budget. A comparatively strong balance of payments will provide a shock absorber, but if the political crisis escalates, the country could succumb to a financial crisis.
Damage. Damage is being done to credit ratings and risk premiums, production and demand, supply chains, confidence, workers’ remittances, and the banking system; and through these channels, to the balance of payments and budget.
Moody's and Standard & Poor’s have both announced ratings downgrades and CDS spreads have risen from 200 basis points to 330 basis points.
Many companies have announced temporary closures. International firms like BG and Nissan are also repatriating staff. Curfews and bank closures, together with political uncertainty, are also reportedly weighing on consumer spending. Tourism has obviously been severely hit, and though holiday-makers can generally be lured back with cut-price deals once the smoke clears, that is small consolation right now to an industry that made foreign revenues of almost US$12 billion in FY2009-10 (July-June). GDP growth, which was almost 5% a year over the past two years, has now undoubtedly turned negative.
Capital flows are another concern. Before the uprising, portfolio and direct investment inflows and workers’ remittances were all strong. Net FDI inflow, for instance, was equivalent to about 5% of GDP, or US$9 billion in FY 2009-10; workers’ remittances 4%, or US$7½ billion. Portfolio capital is already leaving the stock and currency markets. Worse, overseas Egyptian workers may now curtail their remittances, at least the discretionary part, in expectation of pound devaluation.
The setbacks to public revenue and spending are difficult to gauge at this stage, but are likely to be considerable. In response to the unrest, the government has announced a 15% increase in public sector salaries and pensions, and said it would maintain current subsidies 'in full and without limit'. The subsidy bill was already large before the announcement. Energy subsidies have amounted to 4-7% of GDP in recent years; food subsidies 1-2% of GDP; total subsidies 25% of government spending. To offset this increased bill, the authorities may curtail capital spending.
On the plus side, the army is in control of the Suez Canal and traffic continues undisturbed. This means that an important foreign exchange earner – Canal dues, almost US$5 billion in FY2009-10 – also continue. Still, insurance premiums for ships transiting the Canal are reportedly rising, and this could induce some shippers to take the precaution of going round the Cape of Good Hope. The oil and gas industry also continues to produce undisturbed. There was some concern that when the banks reopened fearful depositors would rush to withdraw funds. There have been some withdrawals, but not amounting to a rush.
Fiscal weakness. As the IMF remarked in its last Article IV inspection of the economy, ‘Fiscal vulnerabilities are Egypt’s main macroeconomic risk’. There are three concerns: a large deficit equivalent to around 8% of GDP last financial year; a large gross public debt equivalent to 74% of GDP; and as a result, a large financing need that has averaged around 25% of GDP in recent years, of which the short term rollover need is now more than 20%. As a result, the Fund believes that ‘The debt outlook remains moderately vulnerable to adverse shocks.’ Because a quarter of the debt is foreign currency denominated, a 30% real exchange rate depreciation would increase the debt/GDP ratio by around 9 percentage points relative to the baseline in FY2014-15.
External durability. In contrast to the budget, the balance of payments is in quite good shape. This is thanks to a balanced current account in recent years and strong economic growth, which together have almost halved the external debt to GDP ratio to 17% in FY2008/09 from 32% in FY2004/05. Foreign reserves are also healthy: US$36 billion, equal to between 5-6 months of current account receipts.
There is another piece of good news. Thanks to the economy’s roughly balanced savings-investment position and correspondingly comfortable balance of payments, the government can – and has – met most of its borrowing needs from the domestic banking and capital markets; its need to tap world capital markets has been small. Egyptian banks have been quite willing to fund the government, because of surplus liquidity; their loan/deposit is reportedly 53%.
Political events critical. It is possible to make the case that the government may be unable to meet its large debt service needs, especially if the political crisis escalates or lingers. But it has some cards up its sleeve. It could go to the IMF for standby credit – if not now, at least when the violence subsides. It also has some capacity to talk local banks into accepting its paper. Finally, there are strong external liquidity buffers in the form of foreign exchange reserves to draw upon in the short term.
If the political crisis escalates, however, the funding pressures could intensify.
Eurozone: Sentiment ebbs and flows, but problems remain
Sovereign debt yields in the troubled peripheral countries have eased over the past month. But there is a risk of renewed sell-off if promises of reform to a eurozone bail-out fund disappoint.
In December, sovereign bond yields in the eurozone peripheral countries widened as markets fretted about the sustainability of public finances in Portugal, Spain and Belgium (Chart 3). Both Spain and Portugal need to issue debt equivalent to 10% of GDP in 2011.
Spreads narrowed through January and early February, as the EU and national officials announced that the bailout fund would be overhauled to ensure it could meet any future debt difficulties. Reforms reportedly being canvassed include: increasing the fund’s size, cutting the rates charged to borrowers, and allowing the fund to buy secondary market debt.
But with these things now priced into markets, there is a risk that a failure by the EU to deliver will cause a renewed selloff. Indeed, in recent days Portuguese spreads have widened on fears a satisfactory agreement will not be reached. One concern is German opposition to the plans. Before agreeing to any beefed up bailout fund, German officials want a ‘pact for competitiveness’, which requires eurozone members to co-ordinate tax, pension and debt laws.
The market is also awaiting another round of eurozone bank stress tests. Market concerns over Ireland and Spain have been more about rising contingent liabilities from bank bailouts, rather than actual sovereign debt burdens. The EU has promised tougher tests than last year, which were roundly criticised for setting the capital adequacy bar too low and assuming no sovereign debt restructuring. The test parameters are expected to be set by March with the results released in June.
Vietnam: Overheating brings vulnerability
The economy is suffering from twin deficits, weak banks, and double-digit inflation.
The authorities’ pursuit of rapid economic growth has come at a cost of macroeconomic instability and rising sovereign risk. Two imbalances that have managed are a large trade and a large fiscal deficit. ‘Twin deficits’ are a rarity in Asia, but the Vietnamese trade deficit reached 11% of GDP in 2010, and the fiscal deficit 6%. In addition, inflation has accelerated – to 12% in January 2011 (Chart 4).
Worse still, a December default by state-owned shipbuilder Vinashin has raised concerns over the banks. Bank credit has been growing rapidly in recent years with most of the loans going to state-owned enterprises at below-market rates. Moreover, some state-owned enterprises have reportedly used these funds to expand outside their core businesses.
These troubles are being reflected in the currency and debt markets. On the February 11, the central bank devalued the currency by 9%. The devaluation was the fourth in 15 months (Chart 5). Meanwhile, ratings agencies have been downgrading Vietnam’s sovereign debt. In December, Moody’s downgraded Vietnam a notch to B1, and S&P followed with a BB-. Fitch had preceded both with a downgrade to B+ in July. All warned of further downgrades. Spreads on Vietnam’s sovereign debt have jumped by 150bp since early December to 410bp above US Treasuries.
In response to the economic troubles, the government has shifted its rhetoric from a pro-growth bias to economic stability, but so far has taken little policy action.
Cote d’Ivoire: Political crisis brings first default of 2011
Cote d’Ivoire has become the first government to default on its external debt in 2011. The default has been precipitated by the contested election. It could be the herald of other poll-inspired debt difficulties in Sub-Saharan Africa.
The government missed a US$29m interest payment on a $2.3b Eurobond in January. The default was triggered by stiff economic sanctions imposed on President Gbagbo after he refused to accept a loss to Alassane Outtara in a November 2010 presidential election widely viewed as free and fair.
The default caused little surprise. Even before the crisis, Ivorian bonds were trading at an 800bp premium above US Treasuries (Chart 6).
But it also has a wider significance. Elections in Africa frequently run into trouble; they can be contested; defeated incumbents can refuse to go. When that happens fragile economies can be knocked into crisis. In the next two years a third of Sub-Saharan African countries go to the polls.
Bangladesh: Over-ambitious policy causes stock market plunge
A stock market bubble has burst provoking protests by retail investors. The bubble and its puncture are the result of the government wanting to have its cake and eat it when it comes to economic policy.
Many emerging markets have been resisting currency appreciation in the wake of strong capital inflows, Bangladesh among them. Its experience, however, highlights the risks of such an approach: the pegging of the currency encouraged strong credit growth, which pumped up a stock market bubble, which has now burst.
Economic theory explains the dilemma, or rather ‘trilemma’, the authorities faced. They wanted to peg the exchange rate (to keep their exports competitive); they also wished to enjoy free international capital mobility and run their own independent monetary policy. But this was an 'impossible trinity'. Both theory and experience says one can pick only two; three will always prove elusive.
For a while it did look like they could achieve all three. The Dhaka stock exchange outperformed most other markets in recent years (Chart 7). In the year to its early December peak, it doubled in value. However, in December the market suddenly reversed and is now down 25% from its peak. The price falls have sparked protests by retail investors who flooded into the market in 2010 in response to the rapid price gains.
The share market boom did not reflect economic strength, but rather excess liquidity in the banking system, a by-product of the central bank’s efforts to resist currency appreciation due to strong capital inflows. Lacking attractive lending opportunities, many banks shovelled funds into the stock market. The authorities tried to rein in this exposure in December, by hiking reserve requirements and capping stock market investments to 10% of a bank’s total liabilities. This triggered the plunge.
A sustained rout could be a large hit to Bangladesh’s already weak banks – which Fitch already views as the weakest in Asia – and in turn the economy. Individual bank exposure is not clear at this stage, but reports suggest some banks have 75% of their assets parked in the stock market.
Roger Donnelly, Chief Economist
rdonnelly@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.