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World Risk Developments - May 2011 (Size 1.5Mb)
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Stories this month ...
The eurozone fiscal / banking crisis escalated ...
Portugal was forced to seek a €78 billion bailout from the IMF and European Commission (EC). And government bond and CDS spreads on all ‘peripheral’ countries – Greece, Ireland, Portugal and Spain – shot up, on rising fears of sovereign debt default.
All four countries are struggling with large fiscal deficits, stubborn recessions and growing unemployment, even after carrying out tough fiscal austerity measures. They are in a Catch 22: the market is demanding interest rates that make it impossible for them to restore solvency, which justifies the market charging those high rates.
Their predicament has led to speculation that they will soon give up the struggle to balance their budgets and return to capital markets, instead seeking debt relief either by giving their bondholders a ‘haircut’ (principal write-down) or by imposing a ‘soft restructuring’ (long stretch-out of principal repayments and reduction in interest rates). Because of this risk, investors have been dumping their holdings of government bonds and refusing to turn up at auctions of new debt.
This has in turn meant that Lisbon and Athens in particular have been unable to roll over their debt at a reasonable price or borrow fresh money to cover their deficits. So Lisbon has had to go to the IMF and EC for a bailout. Athens will probably also have to return to the IMF and EC for a top-up of the €110 billion package it negotiated a year ago.
There are also serious potential knock-on effects to European banks from a sovereign default, because the banks hold a lot of the peripheral sovereign debt and have suffered severe capital erosion from the global financial crisis. Any haircut would thus put many banks’ solvency under severe pressure. For this reason, two ECB board members have warned of dire consequences from a default. Jürgen Stark has said a Greek default would put the 2008 Lehman Bros bankruptcy ‘in the shade’, while Lorenzo Bini Smaghi has ventured that it would be 'political suicide’.
The crisis has left EU governments with a difficult choice. Either they can push for ‘burden-sharing’ by bondholders, but risk a widespread banking crisis. Or the stronger core members among them can shoulder the burden of financing – and eventually forgiving the debt of – the weaker peripheral members. But then, as the Financial Times's Martin Wolf has noted, ‘Greece would lose almost all sovereignty and resentments would reach boiling point on both sides’.
Commodity prices took a tumble ...
Commodity prices fell sharply over 3-5 May on market concerns about a faltering global economic recovery and the end of US quantitative easing – so-called QE2.
A combination of brisk demand expansion from emerging markets, supply bottlenecks, and abundant liquidity stemming from loose monetary policies has been buoying commodity prices and leading to concerns that they were rising above their long-run fundamental value, particularly for exchange traded commodities such as copper, gold and silver. The strong rally was leaving the markets ripe for a correction. This came last week when investors reportedly sold across the board on news that the ECB might be pausing its monetary tightening and that the American labour market was weaker than expected. Markets are also reportedly anxious about plans by the US Federal Reserve to end QE2 in June: this could lead to a combination of rising US interest rates and US dollar appreciation unfavourable to speculative buying.
Does last week's correction spell the end of the commodity supercycle? Probably not. Underlying supply-demand conditions in many markets remain tight. Indeed, prices received a boost on 6 May after a better-than-expected US jobs report before concerns about Greece’s difficulties trimmed the gains.
Still, a worldwide investment boom is underway to augment supply capacity and cash in on high prices. This is highly likely to bring the supercycle to an end at some point, though how far prices will then decline is debatable.
The Australian Treasury notes in its recent Budget Strategy and Outlook that Australia's terms of trade are likely to decline in the medium term as the international supply of iron ore and coal increases and prices come down. But it expects the process to be a gradual one.
Some commentators argue that even if commodity prices do undergo a correction, the price trend should ultimately be upward, as minerals and energy become scarcer and the long run marginal cost of producing them rises.
It is important to realise that one cannot infer a rising long-run price trend from rapid emerging market demand expansion alone. If the long run marginal cost of producing minerals and energy is low, prices will revert to that low level, regardless of demand growth.
A feared collapse of the Doha Round of world trade talks didn't happen ...
WTO members meeting in Geneva failed to break a stubborn stalemate in the talks, but didn't declare the Round dead either.
There was a real risk of the Round collapsing, because talks have been going on for a decade, yet disagreements are as great as ever. The chief sticking point is one between emerging economies led by China, India and Brazil, which reject a demand by advanced economies led by the US for deep cuts to industrial tariffs.
A collapse of the Round wouldn't harm world trade at once. But it would over time encourage countries to negotiate preferential regional and bilateral trade agreements that divert trade from the most efficient channels and increase paperwork costs for businesses needing to meet 'origin' requirements.
Latin America is enjoying an FDI boom centred on natural resources ...
According to a recent report from ECLAC (Economic Commission for Latin America and the Caribbean), Latin America experienced a 40% FDI boost last year, much of which was focused upon natural resources.
FDI inflows to Latin America and the Caribbean increased 40% in 2010 to US$113 billion. Forty three per cent of inward FDI into South America went into natural resources, compared with 30% into services and 27% into manufacturing.
Latin America took 10% of total worldwide FDI inflows in 2010, up from 5% in 2007. Brazil took the largest inflow (US$49 billion), followed by Mexico (US$18 billion) and Chile (US$15 billion).
The largest sources of inward FDI were the US (17%) and Holland (13%). Though China is on a worldwide quest for energy and resource security, and has large financial surpluses to deploy, it came in at only No 3 with 9%. Canada, Spain and the UK accounted for 4% each.
The flows haven’t just been inward. Outward FDI quadrupled to more than US$43 billion in 2010. Mexico was in the lead with US$13 billion, followed by Brazil (US$12 billion) and Chile (US$9 billion).
Political risk roundup ...
Rio Tinto said it had reached an agreement with the government in Guinea over its Simandou iron ore concession, but a number of question marks remain over the deal.
Rio's Guinean operating company will reportedly pay US$700 million to the government and grant it a 35% stake in the project 'in recognition of the resolution of all outstanding issues and finalisation of new investment agreement terms’.
The company has been in a lengthy dispute with the government over the concession. In 2008 a previous government confiscated half of the concession, awarding it to the Benny Steinmetz group (BSG). BSG then sold a controlling stake in its half to Brazilian company Vale for US$2.5 billion.
The deal reportedly also depends on the government revalidating the mining concession and approving a proposed joint venture between Rio and China's Chalco mining group, which has agreed to pay $1.35 billion to take a 44.65% stake in the project.
Newly elected president Apha Conde had said he will review all existing mining contracts under a new mining code currently being drafted as well as granting future licences under that code. He has invited billionaire philanthropist George Soros's Open Society Foundations to help write the code. Mr Soros has said that to invest in Guinea in future all mining companies and their governments will need to comply with the Extractive Industries Transparency Initiative.
A requirement of EITI compliance could create problems for the Rio/Chalco joint venture since Beijing has not signed up to the EITI.
Also in doubt is Vale’s half of the Simandou concession following a recent decision by the government to cancel a proposal by the company to rehabilitate a railway from the project.
Egypt's military leadership is seeking to renegotiate a gas supply contract with Israel that it claims is providing gas at a steep discount.
It has detained the former oil minister and several of his aides for their involvement in the deal and has said it will negotiate a price increase and seek compensation for gas sold at allegedly discounted rates.
Reflecting the unpopularity of the deal in Egypt, saboteurs have bombed or tried to bomb the pipeline three times, in one case halting supplies for a month.
The government’s push to renegotiate the deal could induce Israel and Jordan to search for alternatives. Neither has easy or cheap options, but Israel could turn to huge recently discovered offshore gas fields and Jordan may switch to northern Iraq.
The Venezuelan government introduced a sharp increase in the windfall profits tax on oil producers.
Previously set at a maximum of 60%, the tax will now go up to 80% when the oil price is above US$70 a barrel, 90% when prices reach US$90, and 95% when the price goes above US$100. President Hugo Chavez claims the increase will bring in some US$9-16 billion if oil prices remain high. But the risk is that the move, on top of a series of previous steps to increase revenue, will deter future investment, despite the scale of Venezuela’s hydrocarbon reserves and high prices.
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.