EFIC World Risk Developments - June 2011 

 EFIC World Risk Developments - June 2011 

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Stories this month...

The world economy has entered a soft patch...

World GDP and industrial production growth look as if they will slow in the June quarter to a rate of around 2½% pa – the slowest since recovery began in the September quarter of 2009.

There are various ways to look at the slowdown: by sector, by region and country, and by demand source.

Sectorally, manufacturing seems to be leading the slowdown. The JP Morgan Global Manufacturing Purchasing Managers' Index (PMI) fell for the third month running in May to reach its lowest level since September 2010. Although the headline index remained above the neutral 50.0 mark for the 23rd successive month, the rate of growth was below the average for this period. Rates of expansion eased for manufacturing output, new orders, new export orders and employment.

Geographically, a marked slowdown in the US was the main drag on world manufacturing growth; the US PMI fell to a 20-month low. Among other major regions and countries covered by the survey, rates of improvement eased in the Eurozone (seven-month low), China (weakest since July 2010), the UK (20-month low) and India (4-month low). Among emerging markets, the May PMIs also remained in positive territory, but recorded dips.

In terms of demand, both final demand and the inventory cycle have been acting as drags.

What have been the ‘exogenous’ factors causing demand to fade and firms to meet demand from stocks rather than production? Two stand out. First, the March 11 earthquake in Japan has been a huge drag. It will cause Japanese GDP to contract in the June as well as March quarters, and is bound to have had significant multiplier effects on trading partners as well. Second, rising food and energy prices, partly due to the 'Arab Spring', have curtailed both business profitability and consumer demand.

Fortunately, the prospects for the second half of the year look better than for the first half.

Japan looks as if it is now bouncing back strongly from its post-earthquake slump. Whereas most PMIs fell in May, that for Japan rose. The vehicle industry is at the forefront of the revival, with car firms now rushing to meet unsatisfied demand and rebuild depleted stocks.

Another boost could come from the recent drop in commodity prices. This could convince central banks to ease up on monetary tightening. It could also boost household purchasing power and fatten firms’ profit margins.

So the world does not seem at great risk of another double-dip recession, barring further setbacks. Still, by the standard of past recoveries from world recessions, it is recovering very sluggishly. Among advanced economies, Japan, the Eurozone, and the UK still have GDPs below their pre-crisis peaks.  Ironically perhaps, the economy at the epicentre of the crisis, the US, recovered beyond its pre-crisis peak last year. OECD-wide output is expected to surpass its pre-crisis peak level only by the middle of this year. Click here, page 16 to view the different recovery profiles.

The focus of the Eurozone debt crisis has shifted from Portugal back to Greece.

Athens is in negotiations again with ‘the troika’ of the European Commission, the European Central Bank and the IMF for more emergency funds on top of the €110 billion it secured in May 2010.

Last month, we reported how Portugal was forced to seek a €78 billion bailout because it couldn't satisfy its funding needs from the bond market. This month the spotlight turns back to Greece.

Despite tightening its fiscal stance by 7%-pts of GDP in 2010, the government has failed both to meet the fiscal goals of its rescue program and to restore market confidence.  As a result, it looks unable to tap the bond market for the €27 billion in 2012 and €38 billion in 2013 that its rescue program requires. So it has had to go back to the troika for more funding. Meanwhile, the Greek banking system, in a similar position to the government, has become reliant on the European Central Bank for its funding.

The troika and Athens will need to come up with more emergency funding over the next few weeks or the government will be unable to repay its maturing debt. The two sides are currently haggling over how much extra fiscal austerity Athens will deliver in return for the necessary funds.

There are two large obstacles to an agreement being reached: ‘austerity fatigue’ in Greece and ‘bailout fatigue’ amongst core European countries. The Greek government is meeting considerable political and public opposition to its plans for further budget cuts and privatisations. And meanwhile, Germany in particular wants to see ‘burden sharing’ imposed upon private holders of Greek sovereign bonds; in other words long extensions to the maturities of their holdings. The ECB adamantly opposes such extensions, believing they could prompt the ratings agencies to downgrade Greece to 'selective default' or 'default’, which could have adverse knock-on effects to other peripheral countries.

In the end, extra funding will probably be extended to avoid default in the near term. But this won't tackle the underlying problems of fiscal insolvency in Peripheral Europe, nor the corresponding problem of inadequate capital buffers in Eurozone banks. Until these underlying problems are tackled, the debt crisis will continue to smoulder.

WRD June 2011 - Chart 1

The US bond market is reacting calmly to talk about technical sovereign debt defaults and 'vigilantes'.

It seems more concerned about the hesitant economic recovery than technical default.

The US federal government is facing three fiscal problems.

First, an immediate cash problem. This stems from the fact that the government reached its statutory borrowing limit of US$14.3 trillion on May 16. Using ‘extraordinary measures’ the Treasury will reportedly be able to keep borrowing till August 2.  But it will then have no borrowing authority left and cash balances will be ‘inadequate’ for it to meet all of its commitments, including potentially debt service.

Second, it has a longer term potential solvency problem stemming from large projected structural fiscal deficits.

Some people argue that the government also has a third problem: a short term funding problem stemming from the fact that bond market vigilantes could soon demand much higher interest rates for their loans in light of the stubborn fiscal deficits and steadily rising public debt.

There is considerable agreement that despite the games of brinkmanship being played in the US Congress over the statutory debt ceiling, it will be raised in time to prevent the government having to scale back programs drastically – either that, or run up arrears to benefit recipients, suppliers, employees or creditors in what would amount to a 'technical' default.

There is also considerable agreement between politicians, ratings agencies and economists that the government will have to do systematic fiscal consolidation in the longer term to maintain its solvency.

Where disagreement comes in is whether the government can afford to postpone fiscal consolidation in the short term. Keynesian economists argue that the government both can and should continue to run large deficits, and probably increase them, to support the economy as the over-indebted private sector struggles to get back onto its feet.  Another school of economists lays more stress on ‘sound finance’. It worries that if the government doesn't move to balance its budget at once, the bond market vigilantes will strike.

So far, the bond market seems to be maintaining its confidence that all three risks will be avoided.

WRD June 2011 - Chart 2

Yields on government securities are low in both nominal and real terms – and coming down.  Evidently, concerns about the economic recovery are trumping worries about a missed coupon or two. (At this stage, no one seems to think it could get more serious than that.)

Interestingly, in the credit default swap (CDS) market – where one buys insurance against default – something different is happening. The cost of default protection for 5-year Treasury bonds is rising. Spreads on 1-year CDSs have spiked even more severely, from 25bp to 52bp since mid-May.  The cost of a 1 year CDS is now higher than for Brazil and Indonesia.  This prompted the Financial Times to write recently, US default more likely than in Indonesia. This is a little alarmist, because the spreads remain low in absolute terms.

Political risk roundup...

The July 3 general election in Thailand could deal a political shock to the economy.

The contest will be one between ‘red shirts’ and ‘yellow shirts’. Investors favour the red shirts – Prime Minister Abhisit Vejjajiva's Democrat Party – as do the urban middle class and armed forces. Outside the cities the yellow shirts in the main opposition Puea Thai Party (PTP), backed by exiled former Prime Minister Thaksin Shinawatra, are more popular.

A problem could arise if Puea Thai score a majority victory. The urban elite rejects Puea Thai, and might challenge the result in court. If a settlement is not reached, or the disagreement is taken onto the streets again, the armed forces could intervene.

A foreign reserve drain has forced the ruling military council in Egypt to seek financial help.

The political unrest has dealt some severe economic blows. Things that should be going up are going down: FDI, tourism, exports, remittances, tax revenues, the share and bond markets. Things that should be going down are going up: inflation, public spending and the fiscal deficit.  And money that should be flowing in is now flowing out, as Egyptians and foreigners alike sell bonds and shares and seek to send the proceeds abroad.

The most serious immediate consequence has been a large balance of payments deficit. The central bank has elected to deal with this deficit by financing it, which has kept the Egyptian pound stable. But the price has been a sharp foreign reserve drain (and sharp drawdown of central bank foreign currency deposits from the banking system), estimated to total US$16 billion since the end of last year.

To help stem the drain, and more broadly to help finance its budgetary and external funding gaps, the government has gone cap in hand to various multilateral and bilateral partners. It has already reached agreement with both the IMF and World Bank. The Fund has agreed to extend a 12-month, US$3 billion standby loan.  The Fund’s executive board will consider the loan next month.  The World Bank has reportedly pledged US$4½ billion over the next two years.  Even the EBRD has said it would be prepared to lend to Egypt for the first time.

Among bilateral partners, Saudi Arabia, Qatar, the US and others have also promised support.  Saudi Arabia has said it will extend US$3¾ billion in grants and concessional loans, which could trigger similar support from other countries. The US has said it will provide up to US$1 billion in relief through debt swaps and another US$1 billion of OPIC guarantees.

This assistance should help to rebuild foreign reserves and stabilise the balance of payments, but the risk will nonetheless remain of a run on the pound that forces the authorities to do one or more of: devalue the pound sharply, let the exchange rate go, or ration foreign currency through exchange controls.

Investors in Peru are wondering whether the new president-elect, Ollanta Humala, is a far-left Hugo Chavez-like character or a centre-left Lula da Silva type.

At this stage, he looks to be more like Lula than Chavez.

He clinched his victory against opponent Keiko Fujimori, the daughter of a previous president, Alberto Fujimori, in a second round of presidential elections on June 5. The following day, the stockmarket fell more than 12%, reportedly on fears that he would wrench economic policy leftward.  However, on June 7 it rose 7%.

During the election campaign, Humala ditched some of the more radical planks of his platform, such as revising trade liberalisation agreements and aspects of the 1993 constitution that provide guarantees to investors. He also stressed the need to maintain business confidence and welcome foreign investment.

Both Standard & Poor's and Fitch have stated that Humala's approach is moderate enough to ensure economic stability, while Moody's has said that the country's investment grade rating is not in jeopardy.

Nevertheless, like other candidates, Humala remains committed to introducing a windfall tax on mining companies to ensure the Treasury benefits from high commodity prices.

Incidentally, Humala wouldn't be the first Peruvian politician to change his spots. During Alan Garcia's first term as president over 1985-90 he pursued policies of macroeconomic populism that led to hyperinflation and crisis. Yet in his second term over 2006-11 he followed more orthodox policies, under which the economy prospered.



Roger Donnelly, Chief Economist

Dougal Crawford, Senior Economist

Ben Ford, Senior Economist

The views expressed in World Risk Developments are EFIC's. They do not represent the views of the Australian Government.