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World Risk Developments - March 2011 (Size 2Mb)
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Japan: Nuclear uncertainty complicates quake damage assessment
As horrifying as the death and destruction from the earthquake and tsunami have been, there were grounds initially for saying that the Japanese economy would quickly recover. There still are such grounds, but the escalating nuclear crisis has introduced more uncertainty to the outlook.
Kobe benchmark. Before the gravity of the damage at the Fukushima nuclear power plant became apparent, many analysts were taking the Kobe quake of 1995 as their benchmark for what could happen. That quake had little discernable impact on GDP: in the three quarters after the quake struck in January, GDP expanded at a 3% annualised rate (Chart 1). This was despite the quake causing more than 6000 deaths and US$120 billion of property damage, equivalent to 2½% of 1995 GDP, according to the IMF.
The recent quake has hit a more agrarian and sparsely populated area than the Kobe quake. Then again, the recent quake has been bigger, has affected a larger area, and has done more severe damage. Quite apart from whatever damage the nuclear incident inflicts, the quake has caused extensive damage to the national power and transport grids. As a result, rolling blackouts are expected at least till end-April, hitting power supply to industry as far as the industrial Shizuoka and Kanagawa prefectures. Rail transport – freight and passenger – in the entire Kanto and Tohoku regions has also been hit hard. There are also nationwide reports of petrol shortages.
In addition, the recent quake has hit at a time when Japan's public debt is much more burdensome, and therefore, according to some analysts, the government has less 'fiscal space' to accomplish reconstruction. What is less remarked upon is the fact that Japan's net external assets have also risen markedly since 1995, and Japan remains the world's largest net external creditor (Chart 2).
Taking all of these factors into consideration, analysts began to settle on a consensus. This said first that the short term hit to GDP from the recent quake would be larger than from Kobe. Second, the economy could quickly bounce back as the economic disruption faded and reconstruction got underway. Overall, there seemed to be little case for marking down pre-quake GDP forecasts for 2011 as a whole.
Nuclear uncertainty. But then the gravity of the nuclear situation began to escalate quickly. In rapid succession, various experts began to upgrade the incident from a Level 4 on the International Nuclear & Radiological Event Scale to a Level 5 or even 6. Level 4 means an ‘accident with local consequences'. Level 5 means one with ‘wider consequences’ similar to the Windscale (UK, 1957) and Three Mile Island (US, 1975) incidents. Level 6 – ‘serious accident’ – is just one level below the most serious Level 7, to which the worst nuclear accident, the 1985 Chernobyl incident in the Ukraine, belongs.
If the nuclear crisis does escalate further, with radioactive material spreading widely across the country, the economic damage could also correspondingly rise.
Bilateral trade. Because Japan is a highly globalised economy, the quake impact can transmit itself through various trade, financial and confidence channels to the rest of the world.
As to the consequences for Japanese-Australian bilateral trade, these are some pertinent facts.
- Australia is not as dependent on Japan as an export market as it was in 1995. Then, we sold 25% of our merchandise exports to Japan. Now the number is 14%.
- The Kobe quake did not noticeably hit Australian exports to Japan in 1995. Exports did fall by almost 9% in the March quarter of 1995 in the immediate aftermath of the quake. But there appears to have been a heavy seasonal element in this fall. Exports were up almost 4% in year-ended terms.
- Our main exports now are: coal (coking and thermal) 40% of total; iron ore 13%; beef 5%; copper 3%. Confidential items make up 17% of the total and include LNG and nickel.
- The disruptions to nuclear power will prompt the Japanese power industry to fire up power capacity using other fuel sources. But coal-fired capacity is reportedly working at full tilt. Oil- and LNG-fired capacity should receive the main demand boost.
- Our main service exports to Japan are tourism. Like merchandise exporters, the Australian tourist industry is no longer as dependent on Japan as it was a decade or more ago. Japan is still the fourth largest source market, but its share is declining. By 2009, travel from Japan had declined by 53% from its peak of 814,000 visitors in 1999. The ‘Total Inbound Economic Value’ of the Japan market – a measure of the Australian sales turnover from Japanese tourists – was $1.4 billion. More than 50% of Japanese tourists go to Queensland.
- Japan is our third largest source of imports, making up 9% of the national import bill. Cars, trucks, refined petroleum and equipment are major items. Various importers have voiced concerns that because of production and supply chain disruptions in Japan, their supplies could be affected, at least in the short run.
Five implications seem to follow.
- There is likely to be a larger short-term export setback this time than after the Kobe quake regardless of how the nuclear situation plays out. But offsetting that, Japan is no longer such a significant export or tourism market for Australia and we are in the midst of a commodity export boom.
- As reconstruction gets underway in coming quarters, demand for Australian commodities such as coking coal and iron ore could increase.
- Exports of LNG, but not thermal coal, could increase as the Japanese power industry fires up spare non-nuclear power production capacity.
- Japanese tourist arrivals are likely to drop, which will be an unwelcome setback for the tourism industry, especially in Queensland, suffering as it already is from the strong A$ plus the recent floods and cyclone.
- Imports from Japan could suffer short term disruptions. It is likely that Australian tourist numbers to Japan will decline.
International: Further oil supply disruptions could be hard to manage
The world economy can cope with a setback to Libyan oil production because it has spare oil production capacity elsewhere and also strategic stockpiles. But if the unrest spreads to other oil producers, those shock absorbers could quickly be overwhelmed, prompting further price spikes and growth disappointments.
Over the past month the oil price has jumped to US$115 a barrel (Chart 3) on the back of the unrest in Libya, which has hampered its oil exports. Libya produces 1.4 million barrels a day (mb/d) - 1.6% of world production. However, these price gains are likely to be temporary, because there is ample spare capacity and oil in strategic stockpiles to cover the lost Libyan production. Both Saudi Arabia, with 3-4 mb/d of spare capacity, and International Energy Agency countries, from their strategic reserves, have assured markets that they are ready and able to cover the drop in supply.
The chief concern is a spread of the unrest to other MENA oil producers. In that event producers and stockholders might struggle to cover the shortfall and prices could rise further. The countries to watch are Iran, Algeria and Iraq, all major oil and gas producers (Chart 4). MENA supplies 28% of the world’s oil and 19% of its gas.
Events in Bahrain also matter. Bahrain is not a big energy producer, but the protests there have a Sunni/Shia element, raising fears that they could encourage protests by the Shia minority in Saudi Arabia’s Eastern province. The two communities are culturally and geographically close. There are reports already of some small protests in the Eastern Province. And at the request of Bahrain’s royal family, Saudi troops have entered Bahrain, to help quell unrest in the emirate. Saudi Arabia’s Eastern Province is home to some of the world’s largest oilfields and the Ras Tanura terminal, the world’s largest oil export port. There was a previous uprising in the Eastern Province in 1979 after the Iranian revolution.
The impact of a surge in the oil price on the world economy is difficult to gauge, but it could be large. Oil price spikes caused by Middle Eastern unrest have contributed to three of the past five world recessions (1974-75, 1980 and 1990). Some modelling even suggests that the 2008 demand-driven oil price surge was the final blow that knocked the US economy into recession – weakened as it was by the financial downturn.
Which countries/regions would be worst hit?
A rise in the oil price transfers income to oil exporters from oil importers. Since oil exporters save more than importers this can subtract from global demand and hence retard growth. A spike in oil prices can also have harmful second-round effects: on confidence, asset prices, wage demands and hence monetary policy, and on balance of payments funding.
On balance, higher oil prices are negative for developed economies. The US, Japan and most of Europe are net oil importers. Worse still, high petrol prices will strain household finances. There are two consolations: first, these economies have become more economical with oil over successive decades; second, monetary policy is likely to remain loose, because most of these economies are still struggling with spare capacity and unemployment and there is little likelihood of oil prices being passed through to the general price level.
The impact on emerging markets is mixed. Large parts of Latin America (Colombia, Mexico, Argentina) and the former Soviet Union are significant oil exporters. Thus, the rouble has risen by 7% against the US dollar since the start of the year, as oil prices have rallied. But for ‘Emerging Asia’ the rally is negative. Thailand, Korea, Philippines, Taiwan, India, and China are all significant oil importers (to the tune of 2% of GDP and above). Moreover, they have little spare capacity and inflation is rising beyond their central banks’ comfort zones. So there is some likelihood of Asian central banks increasing rates more than they otherwise would have.
China: Communist Party pursues more balanced growth
China’s twelfth five-year plan released in early March calls for slower, more balanced growth.
The authorities have set a 7% annual growth target for 2011-15, down from the previous target of 7½%. Historically, growth has been higher than the target – over 2006-10 it averaged 10%, despite the global financial crisis (Chart 5).
Premier Wen Jiabao has also announced a renewed push to rebalance the economy away from exports and investment and towards consumption. The draft budget for 2011 is consistent with this goal, as it aims to increase rural incomes and boost spending on education, healthcare and social security. Wages are also rising rapidly. Several provinces have already hiked minimum wages this year, by nearly 20% on average. Interestingly, though wages have been rising rapidly, they haven't been keeping up with growth of nominal GDP, so the wage share of national income has been shrinking, and that has constrained consumer spending.
Successful rebalancing of the Chinese economy would be good for both China and the rest of the world in several ways. First, it would increase China's resilience to shocks, which should in turn stabilise world growth. Second, by slowing investment it might also damp commodity demand and commodity price volatility. Third, higher wages should induce China's labour-intensive industries to move to emerging markets such as Vietnam or Bangladesh. This would be a clear plus for them and also China, as it would be gaining more capital-intensive industries with greater labour productivity.
Finally, China’s trade surplus, long a source of friction with the US, would also shrink.
One obstacle to achieving the desired rebalancing could be local governments. In aggregate, local government budgets are significantly larger than the central government’s. Moreover, these local governments are reliant on the construction industry for revenue – by some estimates 50% of their money comes from property development. Weening them off this revenue source will prove difficult.
India: Growth reality could fall short of potential
India has enormous growth potential – enough to make it the world’s No 1 economy by 2050 according to one recent estimate – but it needs to widen and deepen its capital base significantly if it is to realise that potential.
Growth potential. A recent Citibank report identified the country as a ‘3G’ economy – a global growth generator – thanks to its youth bulge, impressive higher education, and strong national saving rate. In Citibank’s view, India’s favourable demography could even enable it to outgrow China to become the world's largest economy by 2050. The report adds a rider, however: the country will need to lift its game on infrastructure development and secondary and primary education – what the textbooks call capital widening and deepening – plus economic liberalisation. Otherwise, the growth will falter – with all of the drawbacks that entails, including high rural unemployment, stagnant real wages and financial vulnerability. Presumably with the Middle East uprisings in mind, the report also warns that India's demographic ‘dividend’ could become a ‘curse’.
Overheating. For now the growth constraints are more evident than the potential. Aggregate supply is pressing against aggregate demand. The economy is overheating. It suffered only mildly from the 2008-09 global financial crisis and recession because it had a small foreign trade sector and little exposure to toxic North Atlantic financial assets. And according to government budget estimates, it is expected to grow at 8.6% in fiscal year 2010 11 (April-March). Helping to keep the economy resilient is a large domestic market propelled by demand from 1.2 billion people and fiscal and monetary stimulus.
The drawback of this speedy recovery is high inflation. The wholesale price index, India’s main inflation indicator, rose 8.3% in the year to February 2011. The more telling statistic is food price inflation, which was 10.7% over the same period. Despite tighter monetary policy by the Reserve Bank of India, which has raised policy rates eight times since March 2010, inflation has remained elevated. This is not that surprising given that base (benchmark minimum) lending rates of 7.6%-8.5% are well out of step with nominal GDP growth, expected to be around 20% in 2010 11, and oil prices are rising (India imports about 70% of its oil needs).
Structural issues. The persistence of high inflation also suggests a deeper supply-side problem – of infrastructure, business supply chains and the labour market failing to keep up with rapid economic growth. Roads are just one example: they compare poorly with those in most other Asian economies. A less obvious example is the limited availability of cold storage facilities and refrigerated transport; as a result, one fifth of all food produced is wasted.
Infrastructure investment. The government has big plans to tackle these infrastructure gaps and is aiming to spend US$1 trillion on infrastructure by 2017. Among other initiatives, it has established an India Infrastructure Finance Company (IIFC) to provide long term financial support to projects – in the form of either direct funding or refinancing. And in his recent budget speech, the finance minister unveiled a suite of new initiatives to encourage private infrastructure investment, including by foreigners.
Investment impediments. Still, despite the high level encouragement, the country’s investment appeal has weakened in the past few months. A series of high-level corruption scandals has been one unsettling factor. The most prominent of these concerns India’s 2G telecom licence auctions; India’s anti-corruption agency is currently investigating whether companies bribed officials to sell the companies mobile phone licences at undervalued prices – at an estimated cost to the public purse of US$37 billion. Investors are also reportedly worried by the inflation breakout and the government’s ability to contain the fiscal deficit.
If supply side limitations aren't tackled, India will struggle even to maintain its recent growth rates let alone grow at China-like rates for an extended period. In a country where some 35% of the population lives on less than US$1 a day (albeit a dollar that buys more than it does in the US) and where population is growing rapidly, any economic slowdown would be a large setback.
Turkey: Recovery hits external constraints
The Turkish economy has rebounded strongly from the 2009 recession. But the recovery has been accompanied by a wider current account deficit (CAD), funded by ‘hot money’ inflows – leaving the economy vulnerable.
In 2010, the Turkish economy grew by 8%, helped along by low interest rates, rapid capital inflow and credit growth, and base effects. But the strong growth has come at the cost of a higher lira and a larger CAD (Chart 6). In 2010, the CAD reached 6.7% of GDP and is forecast to reach 7-8% of GDP in 2011. Worse, the external deficit is increasingly being funded by short-term debt – so-called ‘hot money’.
Overall, Turkey’s gross external financing need (CAD plus maturing debt) is expected to exceed 20% of GDP. This leaves it exposed to a spike in global risk aversion or a stalling world economy. Moreover, unlike many other emerging markets, Turkey's foreign currency reserves are not that large. Its external liquidity ratio (reserves to short-term debt) slipped below the important 100% mark in 2010 and is expected to fall below 80% in 2011.
To try and contain this external vulnerability the central bank has introduced an unorthodox policy mix. It has cut interest rates to limit ‘hot money’ and appreciation pressures, while raising bank reserve requirements to slow credit growth. The jury is out on whether these policies will be successful. It has had some success in slowing portfolio inflows – the currency has fallen by 12% against the euro since November. But credit growth remains stubbornly high, and the lower lira and rising oil prices are increasing the risk of higher inflation. The rising oil price is also adding to the external deficit; all else equal,every US$10 a barrel rise in the oil price widens the CAD by about ½% of GDP according to the IMF.
Ratings agency Fitch noted recently that the wide external deficit may delay Turkey’s achieving its long-awaited investment grade status.
Pakistan: Political violence weakens already fragile state
Recent political violence underscores the deep fractures within Pakistani society and will destabilise an already weak economy.
The opening months of 2011 have seen three major incidents. Two politicians – Salman Taseer, governor of Punjab, and Shahbaz Bhatti, minister for religious minorities – have been assassinated in separate incidents and a car bombing in the city of Faisalabad has killed 20 people and injured 100. Taliban militants have claimed responsibility for the assassinations and their suspected involvement has revived several fears.
The first is that hardliners will gain more political influence vis-a-vis the Zardari government, which has been struggling to keep the support of coalition allies and assert political control. To placate one of its coalition partners, the Muttahida Qaumi Movement, the government has already had to reverse plans to reduce domestic fuel subsidies.
The second concern is that the incidents come in a period of especial weakness for the economy in the aftermath of last year's damaging floods.
Finally, there is concern that the violence could undermine Pakistan's US$10.6 billion standby agreement with the IMF. This was already in jeopardy before the incidents because of the government backdown on fuel prices, which had caused the budget deficit to blow out to 8% of GDP, well above the target of 4.7% of GDP agreed in the standby. If there is further fiscal deterioration, the government might forfeit its rights to draw down the remaining standby funds. The agreement has already been extended until September 2011, to allow Pakistan time to complete reform of its general sales tax, and make other fiscal and financial sector adjustments.
Mongolia: Mining boom crowds out other industries
Mongolia is another country, like India, identified as '3G' – a global growth generator – by Citibank. But only time will tell whether it will be able to use the income from a booming mining sector to promote broad-based sustainable development.
The country is about to embark on the construction phase of a mining boom. Although most production is currently small-scale, the country has big plans to expand output. The Oyu Tolgoi deposit could become the world’s largest copper and gold mine and the Tavan Tolgoi deposit has estimated reserves of 6.8 billion tonnes of coal, making it one of the world’s largest unexploited coal deposits.
Foreign investors are lining up contract and investment opportunities. A surge in foreign direct investment into mining over the next few years will probably push Mongolia’s current account deficit towards 20% of GDP. But this shouldn’t be too much to worry about, because it will come with its own capital account financing and once the construction phase ends, and exports start, the deficit should quickly diminish or turn to surplus. Meanwhile, the construction phase will boost growth considerably – the IMF forecasts double-digit expansion for years to come and a quadrupling of per capita GDP by 2018.
As impressive as this sounds, the boom does come with drawbacks. Inflation rose to 12% in 2000 and could accelerate to 20% this year, according to ratings agency Standard and Poor’s. Moreover, Mongolia's traditional exports – cashmere, leather goods and metals processing – are struggling because of rising input costs and a 16% appreciation of the currency – the tugrik – against the US dollar.
A large mining sector will pose other challenges. It will increase Mongolia’s vulnerability to external shocks, notably falls in the price of coal and copper. Sharp falls in copper prices in 2008 and 2009 forced the government to seek IMF support. It will also generate pressures to spend the ‘bounty’ regardless of its volatility and the need to save for future generations when the resources are exhausted. Both main political parties have a liking for such populist spending and there is a rising risk that the parties will be tempted to pursue unsound policies, particularly in the lead-up to the June 2012 elections. Such a combination is economically dangerous – strong resource revenues provide the resources to accommodate populist spending proposals, which in turn raises the ‘break-even commodity price’ for the budget and heightens the economy’s vulnerability to commodity price reversals.
Despite the immense pressure to spend the windfall on cash handouts, the government has, so far, resisted and has secured the legislative passage of a comprehensive fiscal responsibility law. But the law does not formally come into place until 2013 and can be changed with a two-thirds majority in the legislature.
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.