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Roger Donnelly, Chief Economist
rdonnelly@efic.gov.au
Benjamin Ford, Senior Economist
bford@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.
Ireland: Bank resolution proposal resolves little
The Irish government has claimed its recent decision to restructure the troubled Anglo Irish Bank will provide certainty about the cost to the taxpayer of bailing out the banking system. But in fact considerable uncertainty remains about the ultimate cost, and the government's ability to afford the cost.
The finance minister announced on 8 September that he would split the nationalised Anglo Irish Bank into a 'funding bank' and an 'asset recovery bank' – the first a government-owned and guaranteed entity simply holding the bank’s deposit book, not lending; the second an entity holding and working out the bank’s loan book. The minister reportedly feared widespread deposit withdrawals had he gone for a straightforward wind-down of the bank.
He said that that it was ‘essential to identify, with as much certainty as possible, the final cost for the restructuring and resolution of the bank’ and added that the restructuring would ‘bring finality to the problem of Anglo Irish Bank – our most distressed institution’.
This has yet to happen. The meltdown of the Irish banking system during the 2008-09 global financial crisis put the Irish taxpayer on the hook for several large costs: guarantees of bank depositors and bondholders, capital injections, and possible losses associated with the wind-down of impaired loan books. Some of the estimates of the gross public borrowings needed to fund these bailout costs are very large indeed. For instance, the EU Commission’s estimate of the gross cost is 174% of GDP. But they are overstatements, because they ignore the corresponding assets the government has gained and assume all guarantees will be called. Unfortunately the assets to set against these liabilities could be meagre: Standard & Poor’s, for instance, estimates that the government's 'bad bank', NAMA, might raise no more than €16 billion over the next five years. So the net costs could remain large. And if so, taxpayers will have to foot a considerable bill.
This has three implications. First, it is keeping sovereign default fears alive. Credit default swap spreads on 5-year Irish sovereign bonds are now 422 basis points – above Iceland’s. Second, in an effort to stave off such a default, the government is making harsh cuts to public services, civil servants’ pay and social benefits; and such hardship is likely to continue for some time. Third, the heavy cost is leading to calls for greater burden-sharing by bank bondholders. There is no suggestion that the government should dishonour its existing guarantee of bondholders; but there have been calls for the government to allow its existing guarantees to lapse; and to encourage debt-for-equity swaps as a way to recapitalise banks without costing taxpayers. See for instance this Financial Times editorial.
Japan: ‘A yen that wants to be too strong’
A strong yen is threatening the economy's recovery – again.
The latest bout of ‘endaka’ – or currency strength – has seen the yen go up 30% against the US dollar and 40% in trade-weighted terms since mid-2007. The currency is now at a 15-year high against the US dollar and at its highest level since at least 1970 in trade-weighted terms.
The endaka threatens the economy in four ways: by hindering export and import-competing industries, by reducing import prices and thereby intensifying deflation, by encouraging the further shift offshore by Japanese firms of production and procurement, and by inducing those firms staying at home to freeze or cut wages to stay competitive.
The immediate causes of the endaka are two-fold. First, a narrowing of interest rate differentials between Japan and other major economies, encouraging Japanese and foreign investors alike to sell overseas assets and bring funds back to Japan or repay yen loans – the so-called ‘reversal of the yen carry trade'. Second, a recent darkening of the world economic outlook and associated rise in volatility and risk aversion, which has seen investors flee to the safe and liquid haven of the yen.
A third factor has also entered the mix recently: attempts by the Chinese government to rebalance its portfolio of foreign exchange assets out of American assets into Japanese ones.
Underlying all of these factors, however, is the economy’s entrenched savings surplus despite an almost-zero nominal interest rate. Because of the deflation in the economy, the zero nominal rate actually amounts to quite a high real (inflation-adjusted) interest rate. That rate is too high to generate either sufficient domestic investment to keep the economy fully employed, or sufficient overseas investment and net exports to fill the domestic savings-investment gap. The result is ‘a yen that wants to be too strong’. ‘As soon as investors start to think that maybe the worst is over, the yen pops up and undermines the expansion.’ Those are words the economist Paul Krugman wrote in 1999, but they remain apt.
The authorities can combat the endaka in two main ways: first, by selling yen and buying dollars in the currency market to halt appreciation or bring about depreciation; second, through ‘quantitative easing’ of monetary policy with the aim of reversing deflation, getting real interest rates into negative territory and weakening the yen. They have been reluctant to pursue such unorthodox policies in the past, but a line – 83 to the US dollar – was evidently crossed on 15 September. This prompted the authorities to in effect reach for both of the above options. They bought a reported US$20 billion in the foreign currency market and left 'unsterilised' the resultant injection of yen into the market . In the process, they succeeded in pushing the yen down by3% to more than 84 to the US dollar.
The longer run ability of the authorities to resist endaka remains in doubt, however. This will be especially the case if the world economy weakens, prompting investors to seek renewed safety in the yen.
Vietnam: Price controls a risky course
Hanoi is enacting measures allowing it to cap prices on a range of basic commodities. The caps are a risky strategy that may end up frustrating consumers and business alike.
From 1 October the government will have the power to control the price of a range of basic goods including cement, steel, LPG, fertilisers, salt, powdered milk, sugar, rice and coal. The controls will be used only if price movements are ‘abnormal’ or ‘out of step with input costs’. But they will apply to local and foreign, state-owned and private, companies alike, whereas previous controls applied only to state-owned firms.
They are aimed at stemming cost of living increases. Consumer price inflation is currently running at just under 10% a year and has been pushed up by the recent devaluation of the dong (Chart 2).
But the controls could backfire if they create shortages. They will in any case undermine, foreign and local investor confidence already dented by repeated currency devaluations, the government’s persistently high fiscal deficits, and reports of sizeable losses in many of Vietnam’s state-owned firms (see August newsletter).
For more information on Vietnam, see the recently published country profile.
Pakistan: Floods impose severe economic strain
The August floods are a large setback to a weak economy.
The floods have affected 20 million people and one-fifth of the country. Preliminary estimates of the economic cost of the flood vary from US$10 billion to US$43 billion, or 25% of GDP. Agriculture, which accounts for 20% of the economy and provide a living to 45% of Pakistanis, has been hardest hit. The Agriculture Chamber of Commerce has predicted that farm output could fall by 10-15%. Worse, damage to the cotton crop could disrupt the textile industry, a large foreign exchange earner.
As a result, GDP growth forecasts for financial year 2010-11 have been lowered from an already modest 4% to1-3%. Meanwhile, aid and reconstruction costs will place strain on the government’s perilous finances. In November 2008, Pakistan received a US$7.6 billion loan from the IMF (increased to US$11.3 billion in August 2009) to forestall a balance of payments crisis. However, the government was struggling to meet the conditions of the loan, particularly a fiscal deficit target, so the Fund delayed a disbursement. Finally, food shortages are expected to push up inflation, on some estimates to 20% year on year.
Markets are increasingly pricing in the risk of default. The premium on Pakistani sovereign bonds compared to US Treasuries has increased from around 550bp in late July to 640bp (Chart 4). Five year sovereign credit default swaps (the premium charged to insure against default) have jumped to 840bp from 470bp at end-July. Public debt is high in Pakistan at around 60% of GDP, and interest payments consume one third of budget revenues, more than twice the emerging market average.
Because of Pakistan’s importance to regional stability, the international community is unlikely to allow Pakistan’s financial problems to get out of hand. Indeed, so far financial assistance has been forthcoming. The Asian Development Bank has pledged US$2 billion for reconstruction and rehabilitation work. The World Bank has pledged US$1 billion. Bilateral aid packages have also been announced, but concerns over embezzlement and misappropriation, and lack of a transparent policy on aid distribution, are holding back inflows. Pakistan has also entered into negotiations with the IMF to restart US$11.3 billion loan. In the meantime, the IMF has provided US$450 million in emergency assistance.
Sri Lanka: Increased presidential powers ‘undermine democracy’
A recent constitutional amendment has removed virtually all checks on the president's power.
The parliament on 8 September repealed a two-term restriction on the presidency and granted the office new powers. The constitutional amendment will give the head of state the right to appoint officials to the judiciary, police force, election commission and central bank among other institutions.
The defeat of the Tamil Tigers last year after a three decades-long civil war boosted President Mahinda Rajapaksa's popularity and that of his United People's Freedom Alliance party. This in turn enabled it to win the two-thirds majority in parliament needed to amend the constitution. Those amendments have in turn put considerable power in the hands of the president and his family – two of the president’s brothers are ministers, a third parliamentary speaker, and one of his sons an MP.
Reaction to the constitutional amendment has been divided. Washington has said it 'undermines democracy’ and called on the president to ‘strengthen independent institutions, increase transparency and promote national reconciliation’. Sri Lankan opposition and civil rights groups likewise condemned the move.
The market reaction, by contrast, has been a shrug of indifference. Capital markets, at least for the moment, are focusing on the end of the civil war and a US$2.5 billion loan from the IMF. Thanks to this good news, Standard & Poor's raised Sri Lanka's long-term foreign currency rating to B+ from B on 14 September, and the sovereign bond spread has held firm at around 360 basis points over US Treasuries. The government will reportedly start meeting investors soon as part of a plan to sell US$1 billion worth of US dollar-denominated bonds.
For more information on Sri Lanka, see the recently published country profile.
South Africa: Mining companies see increased sovereign risk
A series of controversial decisions by the Department of Mineral Resources (DMR) during 2009-10 altering mining companies’ exploration and development rights is causing concern about security of mineral rights.
Four decisions in particular have received publicity.
- One in May to prohibit platinum miner Lonmin from selling nickel, copper and chrome by-products from its Marikana platinum mine in North West Province. Some of these rights were awarded to the HolGoun Group, led by Givi Gounden, a former government official and Lonmin director. The prohibition was later rescinded.
- A decision in March to award 21.4% of the prospecting rights in the Sishen iron ore mine – owned by Kumba Resources, the black empowerment arm of Anglo American – to Imperial Crown Trading, a politically connected company with little mining experience
- A decision earlier this year to grant Keysha Investments overlapping prospecting rights to North West Province properties controlled by platinum miners Impala Platinum and Lonmin. Keysha has since withdrawn its claim to the Impala concession, but insists on its title to the Lonmin property.
- A decision in 2009 to award prospecting rights over part of Anglo Coal's properties next to its New Vaal colliery in Free State province to Melody Street Trading. Anglo Coal, an Anglo American subsidiary, insists the rights belong to it. Melody Street is a black empowerment company.
These are only the most prominent disputes. There are reportedly many more cases of mining rights being granted under irregular circumstances. Unnerving investors still further have been three separate developments: a call by the ANC Youth Leader Julius Malema for mine nationalisation, criticism by the outspoken mining minister Susan Shabangu that companies were behind in meeting a target to transfer 26% of mining assets to black ownership by 2014, and a proposal to create a state-owned mining firm.
Such had become the state of anxiety that even Shabangu was forced to admit last month that there was ‘growing negative sentiment regarding the South African mineral sector’. She went on to list a series of steps the DMR would take to improve sentiment. These included resolving all cases of overlapping rights within three months and publishing the status of all prospecting right applications on the DMR website. In defence of her department, she noted that it had dealt with more than 25,600 mineral licence applications in total, and only 100 had shown ‘administrative irregularities’.
Mining companies reportedly want assurance in three areas: that no more overlapping claims will be granted, that once a company has gained a BEE (black economic empowerment) partner it will keep its empowered status even if the BEE partner sells out, and that ‘old order mining rights’ granted before the passage of the current mining law will be respected, not replaced with ‘new order rights’.
Mozambique: Protestors’ grievances go beyond living costs
Recent protests against rising food and electricity prices also reflect public resentment at lack of ‘trickle-down’ benefit from capital-intensive economic development.
The government’s announcement of increases in water, electricity and bread prices earlier this month sparked three days of violent clashes in Maputo and other towns. It subsequently reversed its decision to raise bread prices and scaled back the water and electricity price rises, but not before seven people had been killed and 280 injured, the capital paralysed, and the airport shut.
In justifying the increased price of bread, the government cited the higher world price of wheat. But other factors were also at play including currency depreciation and a drought. In 2008, the country experienced similarly deadly protests as part of a worldwide wave of anger against soaring international food prices.
Underlying the unhappiness with cost of living increases has been a failure of the income of many poor Mozambicans to keep up. The minimum wage is 1,300 meticais (US$36) a month, yet the monthly cost of rice is estimated to have risen to 1,000 meticais (US$27).
This real income erosion in turn reflects the nature of Mozambique’s recent economic development – a capital-intensive process hinging on so-called mega-investments in aluminium, gas, coal and electricity, including two Australian projects: Riversdale Mining’s recent Benga coal mine and power station and BHP Billiton’s earlier Mozal aluminium smelter. These mega-investments have driven GDP growth of more than 8% in recent years, along with considerable export expansion, but they have created few jobs and bid up the prices of many local goods and services. In the process, have-nots as well as haves have been created, and the have-nots are not happy.
The problem of growing income and wealth inequality and declining real incomes for the poor might have been avoided if the government had spent the tax revenue from the mega-projects to promote broader development, but it is instead spending large sums to subsidise loss-making government businesses. There have also been problems with graft and corruption that led to a 20-year gaol term for a former transport minister last November and prompted aid donors to suspend disbursements over January-March.
The non-inclusive nature of Mozambique’s development raises the risk that the mega-investments may at some point be wrongly blamed for the country’s growing economic disparities and targeted for protest or discriminatory policy.
Ghana: S&P downgrade looks odd
A recent Standard &Poor’s credit downgrade appears out of step with recent economic developments.
On 27 August, S&P downgraded Ghana’s long-term foreign currency rating from B+ to B, a grade five steps below investment grade. Its reasons? A large fiscal deficit and lack of regulation to deal with forthcoming oil revenues. According to S&P, the government’s fiscal deficit target of 1.6% of GDP by 2012 is unrealistic. It expects the deficit to be around 8½% of GDP in 2010, and decrease only gradually thereafter.
The timing of S&P’s downgrade is odd, as recent economic developments have been relatively positive. Since the new government took office in early 2009 on a pledge of austerity, the fiscal deficit has narrowed sharply. There are still concerns over a backlog of domestic payment and wage arrears, but overall the fiscal deficit is forecast to shrink from 20% of GDP in 2008 to 8% in 2010. Meanwhile, foreign trade has benefited from historically high export prices for cocoa and gold exports and inflation has dropped to single digits for the first time since 2006.
The downgrade has come at a time when government revenues are set to receive a boost from the start of oil production. From mid-next year Ghana is expected to start producing 120,000 barrels of crude oil a day from its Jubilee oil field. Overall, oil revenues are expected to be equivalent to 3-5% of GDP. It is true that for nearly all other oil-producing African countries, oil has not been a fiscal saviour, or indeed boon of any kind. But there are reasons for some optimism with Ghana. First, public debate and discussion has been marked by an acute awareness of the problems in other oil-producing African countries. Better still, a ‘petroleum revenues management plan’ – strongly endorsed by the Revenue Watch Institute – is before parliament and should be passed before oil production begins.
Markets showed little reaction to the S&P downgrade. On 10 September Ghanaian sovereign bonds were trading at historically low levels over the emerging market average (Chart 3). In addition, the IMF reportedly described the downgrade as ‘questionable’.
Bahrain: Sectarian tensions could test economy
Sunni versus Shia tensions on top of some economic vulnerabilities bear watching.
The atmosphere leading up to Bahrain’s parliamentary election at the end of October is becoming increasingly tense. Protestors have been staging nightly demonstrations and the temperature of these gatherings has been rising. In response, the government has since mid-August arrested and charged several leading opposition figures and arrested more than 250 protestors. The backdrop to the rising tension is deepening distrust between the country’s Sunni elite and Shia majority. Shia groups complain that their political voice is stifled by the royal family’s influence over appointments to the country’s upper house of parliament. They also claim widespread discrimination against them for jobs and housing.
The recent rise in sectarian tensions is raising fears of a return to the instability the country suffered during the 1990s, when Shia groups engaged in a campaign of protests and the authorities of arbitrary arrests. The accession of King Hamad to the throne in 1999 saw a welcome easing in sectarian tensions as he sought conciliation with Shia opposition groups. This understanding seems to have come unstuck in recent months due to rising Shia scepticism about the government’s sincerity.
The increase in sectarian tension needs to be seen alongside potential vulnerabilities in the economy. The city-state has earned a reputation for having a well regulated financial centre. Nonetheless, at almost three times GDP, the retail banking sector has grown too large for the sovereign to offer blanket support in the event of distress. The government has become increasingly dependent on oil revenues to finance its spending. According to estimates by Moody’s, the country’s ‘breakeven oil price’ (at which, all else equal, the budget balances) rose to $80 a barrel last year from around $30 a barrel in 2004. Moody’s recently downgraded Bahrain one notch to A3, still investment grade, but one of the lowest assigned to Gulf Arab states.
Ecuador: Contract re-negotiation talk becomes reality
The government is in the process of re-negotiating contracts with the main foreign oil companies. Although most will probably accept the new regime, the radical switch in contractual arrangements will constrain future private investment in the oil sector.
In late July, the government succeeded in passing controversial new laws for the oil industry. These will substantially alter the relationship between government and the industry.
The key feature is a switch from production-sharing arrangements to service provider agreements in which the state agrees to pay oil companies a set fee to extract oil – in effect becoming the sole owner of oil produced in the country. The laws will aso give companies an additional premium if they introduce new extraction techniques or expand the size of reserves.
Negotiations will now focus on the tariff that companies will receive, which is supposed to reflect the extent of risk involved in future exploration and drilling. In principle, riskier projects will receive higher tariffs, but there seems to be scope for substantial disagreement over what constitutes an appropriate level of compensation for risk.
The substitution of service contracts is a model pioneered in other parts of South America, notably Venezuela and Bolivia. It will enable President Rafael Correa to claim credit for re-nationalising strategic assets in the public interest. Against this is the potential to weaken the country’s appeal to foreign oil companies. Oil production, particularly by private operators has been falling steadily since the Correa government came to power in 2007 – from 536,000 barrels a day in 2007 to 486,000 barrels in 2009, with further declines in prospect this year.