In this issue ...

• Recession contours: March quarter GDP not pretty
• Risk takers return: Emerging markets bounce
• Up, up & away: Can the commodity rally last?
• Game-changer? Interpreting India's election result
• Buy Sri Lanka? Now that the war is over

Recession contours: March quarter GDP not pretty

World GDP continued to slump at a 7% annualised rate in the March quarter. There are signs of stabilisation and a weak recovery in H2 2009. But given the size of the prior declines and the likelihood of a slow recovery, the level of global GDP is not projected to return to 2008 levels until 2011.

The rate of GDP decline in advanced economies accelerated in the March quarter. This was largely due to double digit falls in Germany and Japan (see chart). The drop in Germany's GDP was concentrated in exports and related-investment, while the slump in Japanese GDP was more broad-based. Japan shrank at a more than 15% annualised rate; Germany at more than 14%. In Japan, the level of GDP is now 9% below its March quarter 2008 peak.

Partial indicators suggest the rate of contraction is slowing in the June quarter. Monthly export data have firmed, as household spending stabilises after previous belt-tightening and the rate of stock clearance slows. Sentiment has bounced off record lows. A sizeable fiscal package is also coming on stream in Japan. 

GDP numbers in Asia ex-Japan are more positive.

India topped the league tables in the March quarter, with GDP rising by a 6.4% annualised rate. Growth reflected pre-election stimulus, together with higher output in the agricultural and services sectors. Manufacturing output fell in the quarter, but compared to the rest of Asia, manufacturing accounts for a smaller proportion of GDP.

Growth also accelerated in China. Investment is rising strongly, supported by a surge in bank lending and government spending (see chart). While supporting near-term activity, this acceleration in investment growth is risking overcapacity and endangering the health of the banking sector. Investment already accounts for a whopping 44% of GDP in China. Reflation through rising household consumption would be preferable, but this is difficult in the short-term as it requires significant welfare reform to encourage households to save less.

The Indonesian economy also outperformed. Indonesia grew at an annual rate of 5% in the March quarter, while Malaysia, Singapore and Thailand all contracted by more than 5% pa - the laggard of ASEAN has become the leader. How? Three reasons.

• Domestic demand strength. In contrast to surrounding countries, Indonesian exports as a share of GDP have fallen by a quarter in the past decade to 30% from 40%. The failure of export industries to compete and integrate into Asian production networks had previously been viewed as weakness, but it has left the economy less exposed to contraction in worldwide demand.
• A bumper rice crop. Agricultural output rose by 11½% pa in the quarter.
• Good political news. President Susilo Bambang Yudhoyono (SBY) has chosen Central Bank Governor Boediono as his running mate in the upcoming elections, sending a signal that if re-elected, as most commentators expect, he will lead a reform-minded government.

Risk takers return: Emerging markets bounce

Emerging market bond and equity markets are springing to life, amid increasing risk appetite and signs of economic stabilisation. This is lowering debt roll-over and balance of payments risks.

Spreads on emerging market sovereign bonds have declined sharply from their peak of over 800 basis points in October (see chart, left panel). The narrowing of spreads has occurred across all regions. Consequently, after virtually disappearing in late 2008, debt issuance has risen strongly. Several sovereigns, including the Philippines, Indonesia, Turkey, Mexico, Poland, Brazil and China have all successfully raised funds. Over the year to date, emerging market sovereigns have issued US$50b worth of bonds, broadly in line with pre-crisis rates.

Concerns remain about Eastern Europe's vulnerabilities, due to its large foreign currency borrowings and savage recessions. The region continued to experience sizeable net capital outflows in the March quarter.

Emerging market equities have outperformed developed market indices, with investors betting on the emerging world leading the global economy out of recession. Emerging markets have risen by 65% from early March lows, double the rise recorded in developed markets (see chart, right panel). The rally has also coincided with strong net equity inflows, a sharp reversal from the sizeable outflows in H2 2008. Companies are also using higher prices to raise equity to strengthen their balance sheets.

Further sizeable equity gains appear unlikely. Earnings forecasts have not kept pace with rise in the stock market, with forward P/E ratios for Asia ex Japan and Latin America nearing pre-crisis levels. Foreign direct investment (FDI) inflows also remain weak, constrained by a sharp decline in global investment spending. According to the 2008 UNCTAD World Investment Report, global FDI fell by 21% last year.

Up, up & away: Can the commodity rally last? 

Prices for exchange-traded commodities have risen strongly in recent months. But caution is warranted. Some price rises look to have out run the world economic outlook.

Copper prices are 75% higher since the start of the year (see chart). Other base metals, such as nickel, tin, lead and zinc have recorded 30-60% price gains. Oil prices have also rallied to US$71 a barrel, a seven-month high.

These price gains are a significant windfall for the Middle East, Latin American and African economies, which rely on commodity exports. But are they sustainable? Activity in China has increased, but this is unlikely to have offset the continued slump in demand elsewhere. Rather, it seems that the majority of the price rises reflect expectations about future demand, with inventory levels high compared to historical averages. This raises the risk of a retracement if 'real' demand does not pick up soon.

Game-changer? Interpreting India's election result

Several commentators have described the strong Congress Party showing in last month's general election as a 'game-changer', allowing Congress to form a government less reliant on support from the Left and therefore better able to plough on with economic liberalisation and fiscal consolidation. But the reality may fall short of the hope.

For many Indian and foreign investors, the previous Congress-led government was a disappointment when it came to improving the business and investment climate (see table) and reining in the runaway fiscal deficit. But they excused it, because of its reliance for a parliamentary majority on a raft of anti-capitalist and populist parties. The communist parties in particular stalled a range of reforms after 2006, such as raising foreign investment ceilings in insurance, telecoms and retail.

The strong win in last month's election, however, which gave the Congress-led United Progressive Alliance (UPA) 261 seats in the 543-seat Lok Sabha lower house - a near majority - means it can now dispense with the support of these obstructionist parties. That in turn implies that the government may now press on with much-needed industry policy reform and fiscal consolidation.

Policies on pause that business hopes will now come into play include not only looser foreign ownership restrictions, but reforms to pensions and cuts to fuel and fertiliser subsidies that will help trim the bloated budget deficit, now equivalent to more than 12% of GDP for the consolidated public sector. There are also hopes that the government will give higher priority to infrastructure needed to widen bottlenecks in the economy.

This assessment, however, overlooks two important considerations. First, Prime Minister Manmohan Singh has many interventionist inclinations of his own. He was indeed the architect of the major economic liberalisation in 1991, but that was partly because he was facing a balance of payments crisis and had no alternative. Second, the UPA and the Congress Party are themselves wont to play populist politics. They contested the election on a platform of job guarantees for poor rural families, debt write-offs for small farmers, and continuation of farm subsidies.

So limited reforms rather than a big breakthrough are the more likely prospect. The government will no longer be able to use the excuse of leftist obstruction in response to criticisms of reform backpedalling. Perhaps the most positive consequence of the decisive UPA win is that it will usher in a period of stable government.

Buy Ski Lanka? Now that the war is over

The defeat of the Tamil Tigers won't necessarily deliver prompt prosperity and stability.

It certainly presents an historic opportunity to move towards lasting peace between Sinhalese and Tamils after 26 years of civil war. Even a temporary ceasefire in 2002-03 gave a boost to growth by allowing a resumption of trade between the north and south of Sri Lanka. Now that there is a prospect of deeper reintegration and a peace dividend, several financial market commentators have issued Buy Sri Lanka recommendations - noting the healthy yields on offer on government bonds of around 14% (rupee denominated).

Meanwhile, though, ratings agency Standard & Poor's has revised the outlook on the country's long-term foreign currency sovereign credit rating of 'B' to negative from stable. It has cited concerns about external liquidity and unfavourable public finances.

The central bank countered on 21 May, saying that strong workers' remittances and improving investor sentiment were buoying the rupee and adding to official currency reserves; domestic credit conditions were easing; and Standard & Poor's concerns were therefore unfounded. But it also admitted earlier that Colombo has approached the IMF for US$1.9 billion in financial support.

The war against the Tigers and the world recession have both taken their toll on the economy, straining the balance of payments and public finances and denting growth. The current account deficit last year stood at more than 9% of GDP and the budget deficit at around 8% of GDP. External liquidity in particular is now under pressure, with some estimates putting reserves at precarious one month's imports, a 60% decline since mid-2008 (see chart).

While the government may now be in a position to trim military spending (which makes up 17% of total spending), service chiefs have flagged new plans to significantly expand the number of military personnel, citing the need to ensure that the Tigers cannot regroup. Certainly for the foreseeable future there will be a need to maintain a costly security apparatus to counter any remnants of the Tigers, who may resort to familiar tactics of 'asymmetric warfare' - assassinations, Claymore mine attacks etc. The government will also want to spend funds on post-war reconstruction.

The economy will have to overcome some serious immediate problems before it will be able to reap any lasting peace dividend. The longer term outlook for peace and stability will depend upon how successfully the government meets the aspirations of Tamils for greater regional autonomy.

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