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Roger Donnelly, Chief Economist
Dougal Crawford, Senior Economist
Ben Ford, Senior Economist
The views expressed in World Risk Developments are EFIC's. They do not represent the views of the Australian Government.
International: Recovery takes hold but euro-worries emerge
The eurozone has swiftly emerged as a new risk to the world economic outlook.
Latest March quarter GDP estimates show the world's economies in a synchronised, if uneven, upturn – in marked contrast with the synchronised downturn that was underway a year before. Chart 1 shows the contrast graphically. Moreover, in its latest forecasts made last month, the IMF foresees world growth of around 4¼% in both 2010 and 2011 – broadly in line with the 30-year average.
Activity in Asia ex-Japan is powering ahead. The Chinese economy grew by nearly 12% over the year to the March quarter. Given this exuberance, regional policymakers are switching from stimulatory measures to demand-damping ones. Several central banks, for instance, have tightened monetary policy. There is also speculation that Beijing will allow the renminbi to appreciate.
Unlike Asia ex-Japan, advanced economies look set for a more sluggish recovery – disappointing considering the depth of their slumps and the extent of spare capacity and labour that now exists. Growth of around 2¼% is expected for 2010, following a 3¼% fall in 2009.
In March quarter 2010, eurozone GDP grew by 0.8% pa compared to more than 3% pa in the US. This divergence is likely to continue, as eurozone governments rein in fiscal deficits to head off threatening sovereign debt crises.
An even worse scenario is financial contagion spreading from Greece to other peripheral eurozone countries and ricocheting to thinly capitalised eurozone banks, which have large exposures to peripheral sovereign debt. The €750 billion financial rescue package looks as if it will cover the periphery’s financing needs for some time, so this risk is still small. But since there are still concerns about how quickly the rescue funds can be deployed, and the exact size of the need if banks also need to be bailed out, this risk needs to be watched.
A downgrade of eurozone growth would hit world growth quite hard, because the region makes up around 20% of world GDP. It would also hit it indirectly through trade and financial market channels. The eurozone does around 16% of the world’s importing.
See following story for further discussion.
Eurozone: Size of rescue package isn’t only thing that matters
The recently announced €750 billion rescue package seems to have contained the spreading fiscal-cum-banking crisis in the eurozone. But even that isn't assured. And the package has done little to tackle the root causes of the crisis.
Since we reported last month, eurozone events have moved with remarkable speed. The Greek government’s funding needs became unmanageable and it was obliged to seek an EU/IMF bailout to avoid default. That duly arrived – to the tune of €110 billion – but other countries then came into the sights of the rating agencies and ‘bond market vigilantes’ – notably Portugal and Spain, but also Ireland.
Moreover, it started to dawn on the market that many of Europe's thinly capitalised banks had loaded up in a big way with bonds of the peripheral eurozone countries. So their solvency came into question. Even banks that didn't hold many or any of the problematic bonds, but had made loans to banks that had, came into question. In the process, many banks found themselves unable to borrow in the interbank lending market, and had to rely on the European Central Bank for funding – in an eerie echo of a similar freeze in inter-bank lending in September 2008 after the collapse of Lehman Bros. Greek and Portuguese banks as a whole found themselves in this position, and even some core eurozone banks have reportedly had similar difficulty. Meanwhile, all banks have had to endure widening risk spreads (see Chart 2). A diagram showing Europe's web of debt that has been circulating widely in the blogosphere illustrates the inter-connectedness of the problem. It was through this inter-connectedness that what began as a Greek fiscal crisis quickly morphed into a fiscal-cum-banking crisis in the peripheral eurozone, and then threatened to turn into a wider eurozone crisis.
In response, the EU announced on 9 May that, with help from the IMF, it had put together a €750 billion stabilisation fund from which other countries in difficulty could draw; moreover, this would be buttressed by liquidity support measures from the European Central Bank (see box). Previously under widespread attack for indecisive and disappointing action, the EU decided this time to deliver a surprisingly large package – one almost as large as the estimated financing needs of Greece, Portugal, Spain and Ireland combined over the next four years (Chart 3). This seems to have brought some immediate stability – a wide range of eurozone bond and share markets rallied in the wake of the announcement and inter-bank lending began to flow more freely.
But does this mean that the crisis is over? Almost certainly not.
- Even in the short term there could be problems. In theory, the large size of the funding and guarantee pledge means that the governments in question need no longer go to the bond market. But will they be able to draw upon the package if and when in need? This will depend on other eurozone governments making loan guarantees available. The trouble is, there is growing political opposition in many countries to doing so. In addition, there could be legal challenges to proposed bailouts; this has already occurred in Germany. Finally, the rescue fund may prove to be inadequate to the task, if difficulties in banking systems turn out to be larger than estimated.
- At a more fundamental level, the package does no more than provide temporary financial relief. To really tackle their fiscal problems, governments at the periphery will need to carry out large spending cuts and tax rises to shore up their solvency and deep structural adjustments to boost competitiveness. The trouble is the fiscal and structural adjustments needed are probably beyond these countries’ ‘pain thresholds’, especially since they won't be able to reach for the option of devaluation to spur export-led growth. (It is true that the euro is depreciating, but the peripheral countries trade in large part with other eurozone members.) It is therefore quite thinkable that they will be unable to repay their EU-guaranteed loans when they fall due, and at that point will either have to default outright, or persuade EU governments to extend their loans.
- At an even more fundamental level, the package does nothing to rectify design flaws in the eurozone model. Importantly, lenders to the periphery thought they had an implicit financial guarantee from core eurozone members and the European Central Bank. This encouraged reckless lending by core countries with financial surpluses; and equally reckless borrowing and the running of large financial deficits by peripheral countries (private borrowing in some countries, public in others). Both core and periphery thought their unsustainable behaviour could go on, but in the 'new normal' conditions now prevailing that delusion has quickly been extinguished. Efforts are now underway at the EU to strengthen the stability and growth pact that is supposed to discipline profligate governments with debt and deficit limits so that they don’t live beyond their means again. But there seems little recognition that profligate borrowers can only borrow recklessly if surplus countries are prepared to lend recklessly. Such a recognition would imply symmetrical restraints on the accumulation of both surpluses and deficits.
So the rescue package may well postpone a sovereign debt crisis in Greece and other peripheral countries. Even if it succeeds in averting debt repayment problems, however, those problems are likely to resurface when the EU-guaranteed loans to Greece, and possibly other countries, start to mature. Moreover, the package hasn't relieved eurozone members of the need to have a deeper discussion of how in future to avoid the imbalances that have led to the present crisis.
Eurozone: Does contagion threaten countries outside the zone?
The eurozone crisis has prompted the question: Who might be next? Neither emerging market governments, nor even the US and UK, look to be as crisis-prone as the peripheral eurozone members and the eurozone banks which lent to them. None of this to imply that other regions can be indifferent to eurozone travails: the eurozone is an important supplier of capital to the rest of the world, and a sizeable importer.
Unlike in previous sovereign debt crises, it is advanced economies, not emerging ones, which this time look under stress. By and large, emerging markets have adopted very cautious macroeconomic policies over the past decade – holding down exchange rates and domestic consumption, running fiscal and current account surpluses, and accumulating large international reserve positions and sovereign wealth funds. They have done so to avoid succumbing to crises like the Asian financial one of 1997. As a result, they generally now have the shock absorbers to ride out bouts of extreme risk aversion in financial markets (Chart 4).
The advanced economies are the ones which now have the largest fiscal deficits and public debt. Some commentators have suggested that where Greece has gone, other peripheral eurozone members will soon follow, with the United States and UK not far behind.
This seems to be an overstatement. In the US and UK, large fiscal deficits have arisen as a result of the collapse of those countries’ private sectors. In the process, tax revenues have gone down and public spending up. But both countries seem to have better recovery prospects than the peripheral eurozone members, and so better prospects of growing out of their fiscal problems. This is not to deny that they do have some chronic problems associated with growing age-related spending on health and pensions and so forth. But these problems are unlikely to go acute in the immediate future.
That certainly seems to have been the judgment of the bond market. As sovereign bond yields for peripheral eurozone countries were soaring in the period before the 9 May announcement of the EU rescue package, they were actually falling for the US and UK (Chart 5).
As the previous story noted, the place to look for the next phase of the crisis is not emerging markets or advanced economies outside the eurozone; it is rather peripheral eurozone governments and the banks which lent to them. The €750 billion rescue package reduces the risk of immediate contagion, but the situation bears close watching because of the underlying financial fragility.
One number to keep in mind if a wider eurozone sovereign-cum-banking crisis did come to pass is this: the eurozone does 16% of the world’s importing. So a curtailment of its imports could be a sizeable setback to global growth.
The eurozone buys about 12% of Asian exports, again a significant number. Fortunately, many Asian countries have scope to expand domestic demand to cushion falling exports, thanks to current account surpluses. But there would still undoubtedly be a perceptible growth drag through reduced exports, reinforced by effects on financial markets and confidence. According to media reports, Beijing may be considering delaying plans to allow the renminbi to appreciate because of euro-worries.
Thailand: Political conflict threatens 'bullet-proof’ economy
A sharp deterioration in relations between ‘red shirt’ rebels and the 18 month old Democrat led coalition government threatens to polarise the country further and derail the economy’s recovery.
Military crackdown. After weeks of rising violence, the army moved in decisively on 19 May to retake the red shirts' protest site in the Ratchaprasong area of Bangkok. The retreating protesters set fire to the landmark Central World department store and also attacked the stock exchange. The army's action followed a breakdown in talks the previous week between the government and the protesters.
Although the red shirts have now largely been dislodged from the capital, the crackdown will do nothing to answer the protesters’ underlying grievances and has probably snuffed out any chance of a political agreement along the lines of the one discussed last week, which would have seen early elections in November. Further sporadic violence is now likely as more militant elements among the protesters continue direct action.
If anything, the show of force may have deepened internal divisions within the two sides, and in the armed forces. Although it is tempting to see the protests as ‘rural poor versus urban elite’ or ‘pro-versus anti-Thaksin’, the truth is more complex. The red shirts appear to be backed by various Thai business, media and political interests, as well as radical elements and communist veterans. Splits have also become visible within the Abhisit-led coalition, with some smaller parties calling for early elections while others back stronger action against the protesters. Within the armed forces, some leaders have been less willing than others to use force against the protestors.
‘Bullet-proof’ economy? The good news until recently has been the economy’s resilience in the face of these political shocks. One reason is that key industrial clusters lie well away from Bangkok. After an initial period of softness in late 2008 and 2009, the economy has been steadily improving, particularly over the last few months. Exports, domestic demand, manufacturing production and private investment (Chart 6) have all powered ahead, while international tourist arrivals were also gradually recovering - till recently at any rate (Chart 7). Meanwhile, the stock market has continued to improve, despite some daily spikes (Chart 8), and the country’s external position has strengthened, with the current account surplus rising to US$5.3 billion in March 2010 from US$4.3 billion in December 2009.
The story on FDI is more mixed. Anecdotal evidence is quite positive. In a recent survey, Japanese investors rated Thailand as their fourth most preferred investment destination, up from fifth place in the previous survey. Japan is Thailand’s largest source of FDI. Other reports suggest that foreign companies with big current stakes in the economy – GM and Honda, for example – are staying put and proceeding with planned expansions. Abstracting from the political noise, the underlying investment climate remains sounds, with a generally solid regulatory environment. In addition, the country's good infrastructure allows it to act as a transport, logistics and administrative hub for business in Indo-China and Southeast Asia. Australian investors also appear to be relatively unaffected. For example, ASX listed goldminer, Kingsgate Consolidated, has reported no effect from the unrest on its Chatree mine in the north.
Yet official statistics show FDI has fallen from 5½% of GDP in March 2006 to around 2% of GDP now (Chart 9). March 2006 was the time that politics took a turn for the worse with the three main opposition parties deciding to boycott snap elections called by then Prime Minister Thaksin Shinawatra. It therefore seems that while many existing investors are sitting tight and holding their nerve, new investors have been withholding additional capital.
Signs are also starting to appear that the political situation is acting as a drag on foreign tourist arrivals. Early reports suggest that hotel occupancy in Bangkok slumped in March and that tourist arrivals softened markedly in April. Any tourism downturn would be bad news because it accounts for around 7% of GDP and 15% of total employment. In addition, the unrest could be starting to branch out from the capital with reports of red shirt attacks on government-aligned companies in the north and north-east.
If the political situation continues to worsen or red shirt activists move their operations outside the capital, the economy may weaken further, particularly if foreign tourists continue to shelve their Thai travel plans or exports are disrupted by problems at air and sea ports.
One important gauge to watch will be FDI, because growth in Thailand has traditionally been largely FDI-driven.
Philippines: Like mother like son?
Senator Benigno ‘Noynoy’ Aquino, son of pro-democracy icon Corazon Aquino, has been elected as the new Philippine president. Following in his mother’s footsteps, Aquino has pledged to stamp out corruption and restore the credibility of Philippine public institutions. But he may be hampered by entrenched political interests.
The conclusion of the election and Aquino’s large victory has reduced political risk. The massacre of 57 people in Mindanao in late 2009 had raised the prospect of a surge in violence, as local groups vied for political influence. Observers also feared glitches at the ballot box, after reports of technical difficulties with new automated voting machines. Fortunately, both concerns proved unfounded. Election-related violence was lower than normal and the automated system functioned without major incident.
Markets welcomed the result. When it became clear Aquino would win by a large margin, the Manila stockmarket defied the regional trend (Chart 10).
Markets will be looking for Aquino to lower the fiscal deficit, which widened to 3.7% of GDP in 2009, as well as tackle corruption. While some widening of the fiscal deficit was appropriate to offset the world recession, stimulus measures included tax cuts on top of an already narrow tax base, causing tax revenue to slump to less than 13% of GDP (Chart 11, LHS). The low tax/GDP ratio, together with sizeable contingent liabilities in state-owned companies and public-private partnership guarantees, needs to be tackled to limit fiscal risk. Public debt, though on the decline, remains high at 60% of GDP, as do interest payments at 20% of government revenue (Chart 11, RHS).
Over the longer term efforts to raise the growth rate are also required. The Philippines has become the laggard of Asia, with per capita income one of the lowest in the region, in sharp contrast to 30 years ago (Chart 12).
One issue hopefully on the agenda is reforms to the ‘hacienda’ system of land ownership, which denies many ordinary farmers the chance to cultivate their own land. Efforts to improve the business climate and encourage business investment are also needed. The World Bank’s ease of doing business index ranks the Philippines 144 out of 183 countries, below Indonesia (122), China (89) Vietnam (93), and Thailand (12). At 14% of GDP, the current level of investment in the Philippines is at its lowest level on record.
Pledges to date. Aquino aims to cut the fiscal deficit through a crackdown on the widespread avoidance of tax and import duties. Oil smuggling alone costs the government US$½ billion a year. To improve the investment climate the new president plans to streamline the investment approval process, cut red tape and consider changes to foreign investment restrictions. A more controversial policy is a plan to limit tax incentives offered to foreign investors. Investors in the IT and business outsourcing industry enjoy tax holidays of up to eight years. A removal of trade restrictions is also unlikely. In 2008, Aquino voted against the ratification of the Philippines’ Free trade agreement with Japan.
Prospects for change? Aquino received 40% of the vote, giving him a solid mandate for reform. But he will face obstruction from the lower tiers of government where his opponents are entrenched.
- The Marcos family made significant gains at the elections. Marcos's widow, Imelda, won a seat in congress; her daughter, Imee, won the governorship of their home province; and son Ferdinand ‘Bong Bong’ Jr was elected as one of 12 senators. Aquino’s father, Benigno ‘Ninoy’ Aquino, a prominent opposition leader throughout the Ferdinand Marcos presidency, was assassinated in 1983 when he returned from the US to push for democracy.
- Former President Arroyo also won a congressional seat. Arroyo supporters have indicated she may try to become Speaker of the House, from where she could push for the introduction of a parliamentary system to reduce the power of the president.
What’s more, Aquino’s political career to date does not suggest a zeal for reform. His Liberal Party – like most parties in the Philippines – lacks an ideological platform to drive change. His mother largely struggled to meet similar promises in her 1987-1992 term.
Bolivia: Nationalisations undermine Morales’s pro-FDI rhetoric
Recent nationalisations will keep foreign investors suspicious about government efforts to invite them into the mining and petroleum industry.
The May Day nationalisation of four electricity companies, three with significant foreign ownership, is the latest attempt by the government of Evo Morales to exercise state control over ‘strategic’ industries and thereby boost its revolutionary credentials. It builds on a 2006 ‘re nationalisation’ of the natural gas industry and a 2008 nationalisation of Entel, a telecoms operator, following a breakdown in talks with its owner, Telecom Italia.
The nationalisations sit awkwardly with parallel ambitions to attract new foreign investment, particularly to mining and petroleum. Predictably, the amount of new investment has been miniscule, with foreign investors confused about and suspicious of the government's intentions.
Although the economy has performed relatively strongly in recent years, the government’s ambivalence to foreign investors is likely to prove a considerable setback to the further commercialisation of the country’s resources.
Guinea: Despite regime change investment uncertainty lingers
Despite high political risks, interest in Guinea’s mining industry remains surprisingly strong. Long-delayed elections are scheduled for June. A successful poll should help stabilise the political arena. But for miners the risk of contract renegotiation will remain.
The death of President Lansana Conté in late-2008 plunged Guinea into turmoil. The military junta which then grabbed power was economically inexperienced and backpedalled on a promise to restore democracy.
In the large mining sector, which has made Guinea the world's No 1 bauxite producer, its approach was arbitrary and erratic. In 2009 it cancelled the purchase by RUSAL, the world's largest aluminium producer, of the Figuria aluminium refinery on the grounds that it had paid well below the market price. It then presented RUSAL with an US$860m bill for unpaid taxes. In addition, it forced Rio Tinto to give up 50% of its US$6 billion Simandou iron ore concession, which it then granted to Israeli firm BSG Resources (see World Risk Developments September 2009 and World Risk Developments November 2009 for background).
Despite these problems, foreign investor interest has remained healthy. In March, Rio announced a joint venture with state-owned Chinese mining company Chinalco to develop Simandou. And last month, BSG Resources sold half of its Simandou iron ore concession to Brazilian miner Vale for US$2.5 billion. Vale bought the asset even though Rio Tinto still sees itself as the legitimate owner.
With his government under mounting pressure from both inside and outside the country, junta leader Moussa Dadis Camara was shot in December 2009. In his place, an interim government of former junta members and opposition groups took power, bringing some measure of stability. Better yet, long-promised elections were set for 27 June.
Some miners are reportedly betting that the upcoming elections will help lessen political uncertainty. But at this late stage it is still not clear who will win the election, or indeed if the election will occur. The election commission is still to complete voter lists and other preparations. Supporters of Camara are threatening disruptions.
Even if successful elections are held, investment risk in the mining sector will remain high. To shore up its finances – which according to the IMF are dire – any new government could well seek a larger slice of mining revenues. Such action would also be welcomed by the public, as it has yet to see any significant benefits from mining. According to press reports, prominent opposition leader Mamadou Bah Baadikko has stated that he would annul the BSG-Vale transaction if his party gains power.