November 2008 

 November 2008 

In this issue ...

  • In brief
  • International - Credit crisis spreads worldwide
  • International - Credit crisis hits mining
  • Ukraine - Credit and metal shocks push economy to brink
  • Turkey - Ebbing credit tide exposes corporate borrowers
  • Indonesia - Economy should avoid crisis, but will slow
  • Philippines - Open economy exposed to trade/FDI shocks
  • Gulf - External shocks will shake, not shatter, economies
  • Zambia - Contested election result a qualified plus for investors

In brief

Developments since mid-September ...

  • The IMF issued a new, gloomier set of economic forecasts just a month after its last forecast. Prospects for world growth have deteriorated over the past month, because of continuing deleveraging and falling producer and consumer confidence, it said. The Fund projects the world economy to expand by 2.2% in 2009, some ¾ percentage point less than its October projection. Advanced economies are forecast to contract on a full-year basis in 2009, the first such fall in the post-war period. In emerging economies, growth is projected to slow appreciably, but still reach 5% in 2009. These forecasts are based on current policies. International action to support financial markets and provide further fiscal stimulus and monetary easing could help limit the downturn.
  • Ratings agency Fitch undertook a review of the sovereign ratings of 17 major investment-grade emerging markets. It affirmed 13 ratings, downgraded four, and revised the outlooks on seven. Down are Bulgaria and Kazakhstan (BBB to BBB-), and Hungary (BBB+ to BBB). Romania falls into speculative grade - BB+ from BBB - 'as the risk of a severe economic and financial crisis increases'. The ratings outlooks on four countries - Korea, Mexico, Russia, South Africa - have been revised to negative from stable; and on Chile and Malaysia to stable from positive.
  • Beijing announced a large economic stimulus package to counteract the effect of slowing exports and consumption, consisting of 4 trillion renminbi (US$586 billion) of spending on infrastructure and social welfare over the next two years. There are some doubts about whether all of this spending, equivalent to 15% of annual GDP, is additional to spending already scheduled, but it does look to be a significant fiscal stimulus nonetheless. China's economy grew by 9% on a year before in the third quarter, according to the state statistics bureau. Growth in the first three quarters of 2008 was 9.9% - two percentage points lower than the 11.9% growth recorded in 2007. According to investment bank JP Morgan, fourth quarter growth could slow to a 4.4% annual rate before accelerating again.
  • US GDP declined at a 0.3% annual rate during the third quarter, the Commerce Department reported. The contraction is expected to deepen sharply during the fourth quarter.
  • Thousands of civilians fled their homes in the eastern North Kivu province of the Democratic Republic of the Congo (DRC), bordering Rwanda and Uganda, after rebels from the National Congress for the People's Defence (CNDP) began marching toward the provincial capital, Goma. Around 250,000 civilians have fled since August when a ceasefire between the government and a variety of armed rebel and militia groups broke down. UN peacekeepers have been unable to keep the peace since and the region is becoming increasingly violent and lawless. The CNDP says it is fighting for a greater say for its Tutsi ethnic group in the DRC's democratic process, though some analysts note that the Congolese army and the rebels are also fighting for rich mineral deposits in the area. Benchmark tin prices increased 31% on 27 October, the day after the rebels stepped up their fighting in this tin-rich region.
  • The price of crude oil dropped below its five-year average. It peaked at US$147/b in July, but by end-October had fallen to nearly US$60. According to many analysts, the current price is approaching the marginal cost of production set by high-cost producers in places like Canada's tar sands and Venezuela's Orinoco heavy oil belt.
  • Former Indonesian central bank governor Burhanuddin Abdullah was fined 250 million rupiah (US$ 23,250) and sentenced to five years' gaol for mis-directing state funds. With the support of President Susilo Bambang Yudhoyono, the state anti-corruption commission has been pursuing an anti-graft campaign against high-profile individuals.
  • The credit crisis forced a growing list of emerging markets to seek IMF help, including: Hungary, Iceland, Turkey, Ukraine, Pakistan, Georgia, Serbia and Belarus . Hungary has secured a US$25 billion package and Ukraine US$16½ billion. Baltic and Balkan countries could be the next candidates to seek Fund help.
  • The Baltic Dry Index, a measure of world freight costs , fell to its lowest level in six years. It tumbled 71% in October alone, to be down 93% from its May peak, and then fell another 4% in the period to 11 November. Rates are plunging as importers facing slowing demand cut and cancel orders. Another factor behind the nosedive is reportedly tightening trade finance - an importer and exporter want to do a deal, but at the margin the importer's bank is unwilling or unable to open a letter of credit (L/C) or the exporter's bank is unwilling or unable to accept the L/C.
  • Germany's foreign minister warned on 28 October that the IMF had less than a week to prevent a full-blown financial crisis in Pakistan . Pakistan needs US$4 billion-5 billion for the financial year to June 2009 to meet foreign debt payments and other liabilities, according to finance ministry officials in Islamabad. The government is in talks with the IMF for a loan of up to US$15 billion. It has also called a meeting of its Western and Gulf Arab allies in Abu Dhabi on 17 November to mobilise financial support. Citing a lack of financing, ratings agency Moody's downgraded Pakistani government bonds to B-3 from B-2.
  • Following the sudden slump in commodity prices , a raft of companies said they were reviewing their multi-billion dollar capital spending plans: Rio Tinto, Arcelor Mittal and Anglo-American among them.
  • Russia's stockmarket closed on 24 and 27 October following outsized price falls. It is down 70% from the start of the year. Despite large current account surpluses and foreign assets, many Russian banks and companies are finding themselves overextended during the current credit crisis and commodity price slump - and are having to retrench severely. This includes, notably, mining companies and banks. Sberbank, the largest retail bank, announced plans to cut a quarter of its workforce, or 70,000 jobs, over the next several years.
  • Cambodian Prime Minister Hun Sen threatened war with Thailand if Thai troops failed to withdraw from a disputed border area.
  • Malaysia's Prime Minister Abdullah Badawi said he would step down in March, four years before his term is due to end, and expected to hand power to his deputy, Najib Razak. Abdullah has been under heavy pressure to resign since the March 2008 general election, at which his party suffered heavy losses.

International - Credit crisis spreads worldwide

October was the month the transatlantic credit crisis went global.

Last month, we warned that - because of the run on the shadow financial system - there was now a risk of the transatlantic financial crisis 'going global'. Subsequent events show that the crisis is indeed spreading throughout the international financial system. All but the most insular firms and countries are feeling knock-on effects.

  • Vulnerable economies we long predicted could face difficulties when the credit tide turned, are: Ukraine, the Baltics, Hungary, Pakistan, Iceland.
  • Others such as Turkey are coming under external funding pressure, even though they haven't been beached.
  • Even more solvent and resilient economies are finding that they aren't immune when loss of confidence is complete, eg. UAE, Kuwait, South Korea, Russia, Indonesia.
  • Virtually all advanced industrial economies have seen the need to shore up their banks through some combination of: interest rate cuts, unsecured as well secured loans, 'cash for trash' swaps (purchases of toxic mortgage-backed securities), public underwriting of capital injections, and deposit and inter-bank lending guarantees. The broad template seems to be the plan announced by the British government on 8 October. In taking these steps, central banks are doing things they have not seen fit to do since the 1930s - or ever before. In the process, their balance sheets are expanding rapidly, as is borrowing by national treasuries.
  • Because falling metals and hydrocarbon prices have accompanied the financial crisis, commodity-exporting emerging markets will have to be watched closely, especially those that were freely spending their revenue windfalls during the boom. The GCC economies are not at risk here; they budget on the conservative assumption of oil at US$40/b. But risk is increasing in Venezuela, Iran, Nigeria and Indonesia. The debt-laden Venezuelan state oil company PDVSA has reportedly had credit lines fall through recently. In Nigeria, the government has revised down its budget oil price of US62.50/b to US$45, and the central bank has warned that the country's excess crude account will be strained if prices fall below the budget target price. National oil companies in all four countries will find it increasingly difficult in the new conditions of low oil prices and dearer credit to raise capital to fund their expansion plans.

There are two critical moments to mark.

  • Lehman Brothers collapse. This event on 15 September caused 'extreme counterparty risk aversion' (plain English translation: breakdown of trust) and the complete seizure of wholesale credit markets.
  • Concerted government intervention. The recent bank rescue plans, however, seem to have staved off a collapse. In the aftermath, confidence seems to be returning and credit flows resuming. One widely-watched measure of confidence or the lack of it is the so-called TED spread - the difference between the interest rate banks charge one another on 3-month loans (3-month LIBOR) and the interest rate on 3-month US Treasury bills. In normal times banks are willing to lend to one another on almost the same terms as to Uncle Sam. So the TED spread is normally less than 50 basis points. The spread rose to 450 basis points at the height of the crisis last month, but then fell to below 300 basis points by 30 October.

Back to the 1930s? There has been much talk that the world economy is 'going back to the 1930s'. How close are we to a 1929-like Financial Crash and 1930s-style Great Depression? Two points are worth noting.

  • It is difficult to exaggerate the severity of the recent panic. This certainly seems to have been on a scale resembling the 1930s.
  • Yet in the 1930s, central banks stood idly by as depositors rushed to withdraw their money and banks called in loans. The central banks mistakenly thought that this was a healthy 'purge' after the 'binge' of the Roaring Twenties. In fact, what happened was the stock of money and credit collapsed, and deflation set in, forcing highly geared borrowers to default in repeated waves (a virulent process economists call 'debt deflation'). Central banks and treasuries have learnt that to head off such a disaster they mustn't be complacent. So this time, they are taking decisive steps to ensure money, credit - and aggregate demand - don't collapse. 'As a result, the likelihood of a global catastrophe has in fact declined over the past couple of weeks', RBA Governor Stevens said on 21 October.

Running out of ammo? There remains a risk that the panic doesn't subside and central banks and treasuries finally 'use up all of their ammunition' - interest rate cuts, borrowing capacity etc - to fight it. In which case, the world economy could succumb to a Great Depression. But that still seems to be a small risk.

Outlook. The bigger risk is that the world economy will now perform only sluggishly for a protracted period, as bank and non-bank firms alike continue to de-gear and recapitalise. In other words, our earlier 'soft landing' forecast now needs to be revised somewhat. A synchronised G3 recession is in prospect, though growth could still hold up quite well in Asia and the Gulf. In these more difficult conditions, fragile and vulnerable entities, be they countries, governments, banks or companies, could collapse, though they may be rescued by the state if deemed Too Big or Too Important to fail.

International - Credit crisis hits mining

Reduced availability of debt and equity capital and lower commodity prices are forcing - or persuading - mine promoters to postpone projects.

Investment bank Credit Suisse reportedly said on 27 October that the credit crisis could delay around US$50 billion of worldwide investment in new mines and mine expansions planned for 2009.

Limited access to financing may delay for 2-3 years construction of some 300 million tons of iron ore capacity, 5 million tons of copper, 10 million tons of aluminium, and more than 1 million ounces of platinum.

The US$50 billion in jeopardy represents two-thirds of an estimated US$75 billion total outlay scheduled for 2009. This US$50 billion postponement could in turn delay a further US$150 billion over 2010-12. The most affected miners are highly indebted ones such as Xstrata and juniors with little access to finance. Credit Suisse sees such a delay as likely to tighten markets eventually and 'sow the seeds for the next bull market'.

The bank reportedly ascribes all the project delays to the credit crisis. But following the recent slump in commodity prices some miners are deciding themselves to leave resources in the ground till prices recover. Either way, the retrenchment could be large and represents a major change from even 6-8 weeks ago, when most announcements from companies were still bullish

Ukraine - Credit and metal shocks push economy to brink

The worldwide retreat from risk-taking and slump in metal markets has forced the Ukraine to the brink of meltdown, and obliged the government to seek help from the IMF.

There has been a big foreign sell-off of Ukrainian shares which has pushed the stock market down about 70% this year. In addition, foreign banks have been withdrawing credit lines from Ukrainian banks. Finally, rumours of the bankruptcy of the sixth-largest bank, Prominvestbank, has sparked a run by depositors.

Demand for foreign currency from all these investors has in turn pushed the hryvnia down 20% v the US dollar in September. The central bank stepped in to stabilise the currency in the first two weeks of October, but has had to sell US$1.6 billion from its reserves to do so.

Sovereign risk is rising along with banking risk, because the government may have to borrow extensively to recapitalise the banks. With this concern in mind, ratings agency Standard & Poor's on 24 October downgraded its foreign currency sovereign credit rating of Ukraine to B from B+. It has also signalled increased transfer and convertibility risk - risk that the government could restrict access to foreign exchange by non-sovereign borrowers.

At bottom, Ukraine's problem is a very large external financing need over the next 12 months. Before the external funding difficulties arose, the current account deficit (CAD) was equivalent to 7% of GDP and rising, because of falling prices and export volumes for metals, which make up 40% of Ukrainian exports. The country's gross external financing need (CAD plus long-term debt amortisation plus short-term external debt) was equivalent to 147% of foreign reserves. Without external financing to cover this need, a wrenching adjustment would have been necessary, involving big interest rate increases, a sharp currency fall, a deep recession, and a wave of bankruptcies.

To relieve such pain, the authorities have just negotiated a US$16½ billion two-year standby loan from the IMF. But it is clear that this loan won't be sufficient to cover all Ukraine's financing needs. Besides, with President Yushchenko and Prime Minister Tymoshenko at loggerheads, legislation to carry out the conditions attached to the loan, such as fiscal discipline, will be delayed. As a result, the announcement of the loan has failed to restore confidence, and the hryvnia has dropped another 17% since 24 October.

Turkey - Ebbing credit tide exposes corporate borrowers

Like other emerging markets with large external financing needs, Turkey is reliant on the kindness of strangers in offshore capital markets and banks - not a comfortable place to be at the current juncture.

According to the IMF in August, Turkey's gross external financing need will be US$130 billion in 2008 and US$135 billion in 2009. In 2008, this is made up of a US$49 billion current account deficit (equivalent to 6.4% of GDP), US$36 billion in medium/long term debt amortisation and US$42 billion in short-term debt. The trouble is, external financing of this size is no longer available, so the supply of dollars to the foreign currency market has dried up, which has caused a steep lira depreciation. There have also been sell-offs in other markets, causing the benchmark bond yield, for instance, to rise from around 16% in January to close to 25% now.

Unlike in Turkey's two previous financial crises - in 2001 and 1994 - banks are not under severe external funding pressure this time. Since restructuring in 2002, they have considerably increased their financial strength and stability. The average Basel capital adequacy ratio for deposit-taking banks is more than 16% and they are well-funded by retail deposits, with a loan/deposit ratio well under 100%.

The concern this time is with non-bank companies, which have net external debt of US$74 billion, equivalent to 10% of GDP, according to ratings agency Standard & Poor's. This leaves them vunerable to difficultly in repaying debt as the lira depreciates, or in refinancing maturing debt, or both.

The central bank has called for an IMF standby agreement to help ease the funding strain, but there is a lot of political opposition to such a move. With much fanfare, the government repaid its last standby loan in May, and was making much of its liberation from Fund tutelage.

Already economic growth has begun to falter. First-quarter GDP grew at 6.7%, but the second quarter figure was only 1.9%. The economy seems destined for recession as its major European export markets go into a slump.

Indonesia - Economy should avoid crisis, but will slow

Unlike the Ukraine and Turkey, Indonesia runs a current account surplus, not deficit, and so is a net capital exporter. Even so, its debt, equity and currency markets have been battered as foreign creditors withdraw even some existing credit lines and dump Indonesian assets.

One measure of the Indonesian sell-off is foreign holdings of domestic government securities and central bank certificates: these fell below US$11 billion in late October from US$19 billion in early August. In addition, there was a single-day, double-digit plunge in the stock market in early October that led the authorities to suspend trading and ban short-selling. One particular factor driving the sell-off has been concern the Bakrie Group will be unable to refinance US$1.2 billion in short-term foreign loans. Since September the rupiah has fallen from 9600/US$ to at one stage 11,800/US$ - a seven-year low. Meanwhile, the yield on the benchmark 10-year government bond rose to 21% in late October from 15% in mid-October. All told, in October the stockmarket fell 31%, the rupiah 20% ( v the US dollar), and foreign exchange reserves 14%.

To restore liquidity and confidence the government has been tapping US$5 billion in bilateral swap arrangements with China, Japan and Korea; buying back domestic government bonds; and telling state enterprises to repatriate foreign exchange earnings promptly. In addition, Jakarta has announced that it is in talks with the World Bank, Islamic Development Bank and Japan Bank for International Cooperation for US$5 billion in loans.

In response to these steps, the currency and bond markets have retraced somewhat in recent days, with the rupiah rising to 11,200/US$ and government bond yields falling to around 15½%. Better still, ratings agency Standard & Poor's on 7November affirmed its BB- long term foreign currency sovereign credit rating.

It is unlikely that the economy will succumb to crisis because the external and public sectors' solvency and liquidity are strong, and the recent slump in the oil price will enable the government to cut its budget deficit in half to around 1% of GDP in 2009 through reduced energy subsidies. However, the economy will suffer a growth setback through lower confidence, restricted credit, and lower prices and volumes for its commodity exports. (It is true that lower oil prices will benefit the balance of payments because Indonesia is a net oil importer. But this advantage is more than offset by a fall in revenue stemming from price falls for the commodities that Indonesia exports.)

Philippines - Open economy exposed to trade/FDI shocks

The Philippine should suffer limited fallout from the credit crisis, but will receive a considerable trade and FDI setback.

Banks appear to hold few toxic mortgage-linked assets and are well-capitalised. Seven key banks together report combined exposure of only US$386 million to Lehman Brothers - less than 1% of their combined assets. The commercial banks also report a Basel capital adequacy ratio of more than 15% - almost double the 8% minimum.

The failure of AIG and Washington Mutual will have some fallout. AIG has put its Philippine subsidiary, Philam Life, the country's largest insurance company with more than one million policyholders, on the auction block. It may be too big for any local firm to buy.

American financial service firms have been large customers of the Philippines BPO (business process outsourcing) sector, the fourth largest in the world, and their difficulties are likely to be a setback. But at least in the case of Washington Mutual, its new owner, JP Morgan, is a long-standing customer of Philippine BPO firms.

Other hits will be felt by the 8 million OFWs (overseas Filipino workers) and their families. OFWs sent $17 billion back to the Philippines in 2007. Many work in the US non-profit sector as nurses and carers and in the Gulf: they may be shielded. But large numbers who work in US financial service firms - and Gulf construction companies that are now feeling chill winds (see story below) - mightn't be so lucky.

It won't help the Philippines that its No 1 and 2 export markets are the US and Japan, both of which have entered or will soon enter recession. So far Philippine exports to these countries have held up well despite a decline in electrical and electronic exports. But this is unlikely to continue.

Another area that will take a hit is FDI. FDI inflows were down 60% in the first six months of 2008 on the year before. A recent switch by the government to a more liberal mining regime had been attracting investor interest during the commodity boom, but now that mineral prices have slumped, a lot of this interest is likely to fade.

Because of bad news like this, the government has downgraded its growth forecast for 2008 and 2009 four times this year. It now foresees 4.3% growth in 2008 and 4.2% in 2009 - much less than the 7.0% recorded in 2007.

Gulf states - External shocks will shake, not shatter, economies

Credit, trade and oil price shocks are hitting the Gulf hard. Governments will deploy their petro-wealth to cushion the impact, but growth will suffer.

Both the UAE and Kuwait have had to confront the same interbank lending freeze and capital adequacy issues in their banking systems that the G3 economies are grappling with. And like the G3 they have been providing financial support to shore up liquidity, capital and confidence.

On the trade front, the shocks go beyond just the slump in oil prices, because in recent years Gulf states have been using their petrodollars to diversify into tourism, real estate development, financial services, petrochemicals and energy-intensive industries such as aluminium smelting. All of these industries now face considerably more gloomy outlooks as a result of the credit crisis and world economic slowdown.

The UAE looks to be particularly vulnerable. A property glut is developing which spells a price correction in 2009. The share prices of leading real estate developers and home mortgage companies have been plummeting as a result. Worse still, the tourism and conference industries are also heading into tougher times. It is widely assumed that if a government bailout of some strategically important Dubai firm or sector is needed, the financially stronger Abu Dhabi government will come to Dubai's aid.

The Gulf's current account surpluses and large foreign asset holdings will shield it from crisis, but a slowdown is in the offing, which will spell disproportionate trouble for overextended firms. Investment bank Merrill Lynch recently cut its 2009 growth forecast for the GCC from 6.2% to 4½%.

Zambia - Contested election result a qualified plus for investors 

Foreign investors have been heartened by the victory of the establishment candidate in a presidential by-election, but will closely watch a challenge to the result by his opponent, who stood on a platform of resource nationalism.

Government candidate Rupiah Banda of the Movement for Multi-Party Democracy won Zambia's presidential by-election on 30 October, called after the previous president, Levy Mwanawasa, died of a stroke in August.

Narrow victory. Helping Banda to victory was the failure of the two main opposition parties, the Patriotic Front and the United Party for National Development, to unite against him. If they had done so, they would almost certainly have won under Zambia's first-past-the-post electoral system. An additional factor might have been voter apathy: the turnout was only 45% of registered voters.

Disputed result. Independent election monitors, while noting some irregularities, called the election free and fair. However, opposition leader Michael Sata of the Patriotic Front has refused to concede defeat: he has accused the government of 'stealing' the vote and demanded a recount. Despite the opposition disunity, Banda's margin of victory was only 2% - within the margin of error for vote-counting. In addition, the electoral commission didn't have time to update the electoral rolls from the previous 2006 election, and there was a rush to swear Banda in - only two hours after release of the official results. Following the election, 'scores' of Sata supporters rioted in a Lusaka slum and burnt down some market stalls, but the violence appears to be on a much smaller scale than after the disputed Kenyan elections in 2007, and has now died down. The Patriotic Front has written to Zambia's election commission seeking a recount in 78 of 150 constituencies. It also wants the recount to be verified by independent monitors and party officials.

Australian investment. Zambia is seeing increased activity from Australian mining companies, including Equinox Minerals, currently commissioning a US$762m open pit copper mine, and Albidon, which has recently finished building its US$90m Munali nickel mine.

Investor disquiet. During the election, Banda campaigned on a platform of policy continuity, whereas Sata promised to force foreign firms to hand over 25% stakes to local investors. Banda's victory will give foreign investors some reassurance, but they will watch closely Sata's challenge of the result.



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