World Risk Developments May 2010: Spotlight on eurozone, Thailand, Philippines, Bolivia, Guinea

This month's issue of EFIC’s newsletter, World Risk Developments, starts by looking at brewing sovereign debt and banking difficulties in the eurozone.

Eurozone developments have been moving with remarkable speed. What was just a Greek sovereign debt crisis last month has since morphed into a broader problem for highly indebted peripheral eurozone countries and the often thinly capitalised eurozone banks which lent to them.

According to EFIC chief economist Roger Donnelly, the €750 billion financial rescue package announced on 9 May by the EU and IMF, and associated package of measures from the European Central Bank to support secondary market bond prices and bank liquidity, should stave off funding problems for the time being. ‘But even that isn't assured.  What's more, the package has done little to solve the root causes of the crisis’ he adds.

‘The package provides temporary financial relief’, says Donnelly.  ‘But to really tackle their fiscal problems, governments at the periphery 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 therefore quite thinkable that governments will be unable to repay some of the EU-guaranteed loans they have taken out when they fall due, and at that point will either have to default outright, or persuade EU governments to extend their loans.’ 

What do the eurozone travails mean for the rest of the world?  'I can think of four setbacks', Donnelly says.  'First, a significant drag on world economic growth, because the eurozone makes up around 20% of world GDP.  Second, a further drag because the eurozone does about 16% of the world's importing, and its imports are now likely to stagnate, if not fall. Third, some interference to economic activity because the eurozone is quite a supplier of capital and lending to other countries, which is now likely to be scaled back. Finally, some retrenchment owing to negative confidence and wealth effects.'

Which entities look most prone to financial contagion from the eurozone? Donnelly says talk of contagion to the United States and UK is a little overblown.  ‘These countries have chronic, not acute, fiscal problems.’  He notes that while yields on government bonds of peripheral eurozone countries were shooting up, those in the US and UK were actually going down.  He thinks that if the financial rescue package doesn't contain the crisis, it is most likely to spread to other peripheral eurozone governments, and to the eurozone banks which lent to them.

In other stories, the newsletter looks at the Thai political conflict, the recent election in the Philippines, and risks for investors in Bolivia and Guinea.

In Thailand, ‘the economy has proven surprisingly “bulletproof” ’, says EFIC senior economist Ben Ford. 'At least so far.' 

‘This resilience spans GDP growth, the stock market, international reserves and the exchange rate.  Even better, many large foreign investors in the country seem to be sitting tight and holding their nerve.’

‘A worrying, if relatively unremarked, development, though, is a big drop in FDI: from around 5½% of GDP in March 2006, when the political crisis started to escalate, to around 2% of GDP now.  It seems that many existing investors are refraining from disinvesting, but new investors have been withholding additional capital.’

‘Foreign tourist arrivals are starting to fall sharply, too’, Ford says. ‘And that matters a lot in an economy where tourism accounts for around 7% of GDP and 15% of employment’. 

In the Philippines, markets have reacted positively to the election as president of Senator Benigno ‘Noynoy’ Aquino, son of pro-democracy icon Corazon Aquino. According to EFIC senior economist Dougal Crawford, ‘Aquino aims to cut the fiscal deficit through a crackdown on tax avoidance and to improve the investment climate by cutting business red tape. A review panel to consider changes to foreign investment restrictions has also been flagged.  A more controversial policy is a plan to limit fiscal incentives to investors, such as tax holidays.  Decisive action to cut trade restrictions looks unlikely: in 2008, Aquino voted against the ratification of the Philippines’ free trade agreement with Japan.’