World Risk Developments August 2012


ECB's vow to do "whatever it takes" lifts Eurozone spirits

Sovereign bond yields of the troubled eurozone periphery have eased in recent weeks following a vow by European Central Bank President Mario Draghi to do ‘whatever it takes to preserve the euro’.

This is being interpreted to mean the Bank will buy the bonds of troubled governments in the secondary markets to cap their yields and thereby head off self-fulfilling crises – what has been colloquially dubbed using the ‘Big Bazooka’ against ‘bond market vigilantes’.

But while such ‘lending of last resort’ might be necessary to resolve the crisis, it is unlikely to be sufficient. A decisive resolution may also require some further debt write-offs and long-term financing of the eurozone imbalances as they are gradually reduced.

So it is probably too early to call the Draghi vow a ‘game-changer’, as some have.

Asia succumbs to external and domestic growth drags

Australia’s Asian trading partners are feeling the pinch from softening external and domestic demand.

Non-Japan Asia grew by about 5½% yoy in the June quarter – well below trend and down from 2011 growth of around 7.5% (Chart 1). The slowdown has been broad-based, with only Indonesia defying
the trend.

Slowing exports are one factor behind the GDP slowdown. In June, merchandise exports grew by just 4½% yoy (Chart 2). Exports are a major contributor to regional growth, accounting for more than 40% of regional GDP.

Slowing domestic demand is the other part of the story. In China the policy tightening of 2011 to contain property prices and slow inflation appears to be having an effect – GDP growth touched a three year low of 7.6% yoy in the June quarter. Compared to the rest of the region Chinese export growth has actually been strong, with the RBA suggesting this may reflect growing concentration of regional supply chains in China. In India, the economy has been hampered by falling investment, weak business confidence, and high inflation. Indian exports have actually been rising strongly thanks to a slump in the rupee. In Korea, exports have been very weak, but so has household consumption, which managed to grow by only 1.2% yoy in the June quarter, because of high household debt and falling property prices.

With Non-Japan Asia accounting for 54% of Australian exports (70% including Japan), economic swings in Asia have a much larger direct impact on Australian exports than developments in Europe and the US (Chart 3). Exports to the EU account for 9% of total Australian exports, down from a peak of 16% in 2003, and the level of exports is unchanged from 2006 (Chart 4).


China's interest rate liberalisation carries risks

Moves by the Chinese authorities to loosen their tight grip on the banking sector, is not without risk.

To arrest the economic slowdown, the People’s Bank cut its policy rate by 25bp in May and June (Chart 5). The central bank also gave the banks a greater degree of freedom in setting their interest rates. Banks can now offer a 30% discount on the lending rates set by the central bank and 10% premium on the deposit rates. This implies that the margin between the minimum lending rate and maximum deposit rates has narrowed sharply: for one-year terms from 250bp to 90bp (Chart 5 – grey bars).

While these actions have been implemented to encourage lending, they also highlight that the central bank’s control of the financial system is changing. The People’s Bank use of administrative
tools, such as credit targets rather than interest rates, is being undermined by the rise of a ‘shadow banking system’ (non-bank financial institutions and off-balance sheet bank investment vehicles), where savers and borrowers can avoid the Central Bank’s policy directions. In July 2012, bank deposits rose by just 12% yoy – near the slowest rate since the series began in 1998 – as depositors search for a better yield outside the banks (Chart 6).

In the long-term, a move away from credit targets will help smooth China’s credit cycle, reduce the risk of over-investment, and slow the rise of the unregulated shadow banks. However, giving banks more freedom in setting interest rates and competing for loans is not without risk. In some countries such deregulation has led to crisis, as bank risk management strategies have failed to keep up with heightened competition and the falling margin between lending and borrowing rates. In China, a sizeable net interest margin and a captive deposit base has long boosted bank profitability and mitigated weak risk management.


Indonesia shows resilience, but external funding risks rise

The Indonesian economy has been a model of resilience in the face of the slowdown elsewhere in Emerging Asia. But the current account is widening and creating vulnerabilities.

Indonesia’s economy grew by 6.4% yoy in the June quarter, a rate that has been broadly unchanged over the past year and is the second strongest in the region after China (Chart 7, LHS). Unlike most other countries in Asia, domestic activity has been the main growth area (Chart 7, RHS). This partly reflects poor export competitiveness (outside of mining), but also a large domestic market of 240 million people.

Despite this economic resilience, the rupiah has been one of Asia’s worse performing currencies –slipping 10% against the US$ since end-June 2011. This incongruity reflects a rapid deterioration in Indonesia’s trade balance – while exports have slumped, imports have remained strong (Charts 8 and 9). Moreover, capital inflows have not been strong enough to compensate. A weaker rupiah has resulted.

The widening trade – and current account – means that after years of surpluses, Indonesia is becoming more reliant on foreign capital to maintain external stability.

In principle, this should not be a concern. The factors that have driven Indonesia’s economic outperformance – large domestic market, growing population, solvent sovereign – should also encourage foreign investment. True, there is a large gap between Indonesia’s sovereign risk rating (and hence its macro-economic fundamentals) and the broader investment climate, but investment inflows have strengthened regardless (Chart 10). Investment reached 32% of GDP in 2011 the highest on record (data are available to 1979), partly driven by rising foreign direct investment.

But recent changes to trade and investment policies, even though well-intentioned, together with well-publicised mine ownership disputes (see last story), could temper investor enthusiasm. These measures are adding to investor uncertainty and could slow foreign direct investment, just at the time Indonesia should be encouraging additional investment.

More broadly, they suggest that Indonesia’s reform program is stalling. This could lead investors to scale back growth expectations, weighing on inflows into Indonesia’s debt and equity markets – inflows which are already weak (see blue bars Chart 9). Indeed, in April, Standard & Poor’s declined to follow Fitch and Moody’s in promoting Indonesia to investment grade because of ‘policy slippages’. More than 30% of total domestic debt is held by foreigners; including private tradeable securities this figure jumps to around 50%, or US$150 billion. The considerable foreign ownership raises the risk of a sharp fall in the rupiah if investor sentiment deteriorates.


Tempering the bullishness on Mongolia

A populist government plus the slowdown in China are beginning to temper some of the bullishness about Mongolia. Foreign mining investors have stampeded into Mongolia in the last few years. Attracted by the country’s huge reserves of untapped resources and proximity to China, the world’s largest commodities consumer, they have sunk billions of dollars into the small economy.

That the country is a functioning electoral democracy – a rarity in Central Asia - and politically stable has also been an attraction. Mongolia ranks in or around the second top quartile of countries on two political indicators produced by the World Bank – ‘political stability’ and ‘voice and accountability’ (Chart 11). Since its transition from a communist state to a democratic republic in the early 1990s, it has held 11 presidential and parliamentary elections. Power has mostly been transferred relatively peacefully, although the June 2008 parliamentary elections did spark some protests. Mongolia’s reputation for political stability is even more impressive given that power sharing governments are common.

The new government resulting from the June 28 parliamentary elections is one of these coalitions. It will be led by the Democratic Party, a nominally centre-left party that was the junior coalition partner of the larger Mongolian People’s Party (MPP) for most of the past four years. The Democratic Party will join with the Mongolian People’s Revolutionary Party (MPRP), a splinter faction of the MPP led by former president Nambaryn Enkhbayar, and the small Civil Will Green Party, leaving the formerly dominant MPP, which fared poorly in the elections, in opposition. Enkhbayar was recently convicted on corruption charges and sentenced to four years’ prison and this may put strains on the coalition.

The tie-up between the Democratic Party and Enkhbayar’s MPRP could tilt policy towards populism and resource nationalism, because it will give considerable power to politicians who have expressed worries about the limited trickle-down benefits from the resource boom. Enkhbayar has been a vocal critic of the Oyu Tolgoi investment agreement and was behind a letter signed by a splinter group of MPs sent to (former) Prime Minister Sukhbaatar Batbold in September 2011 demanding the agreement be revised to give the state a 50% holding.


Foreign investors are still digesting a new law passed in May that requires both government and parliamentary approval for any foreign investment of more than 100 billion tugriks (roughly US$76 million) if the foreign investors hold a stake of more than 49% in businesses in three strategic sectors – minerals, banking and finance, and media and telecommunications. Many foreign investors have welcomed the new law, though probably only because it waters down an earlier law. Others, notably those in the mining sector with nervous financiers, seem less comfortable with the new investment regime.

Regardless of the concerns, the current bulging investment pipeline shouldn’t be affected too much. In 2011, foreign investment reached an astonishing 55% of Mongolia’s US$9 billion GDP (Chart 12) and investment in 2012 is also likely to be strong. Projects with uncommitted customers and financiers may be in more doubt, although not necessarily because of populist policies.

Instead, they could be shelved because of changing economic fundamentals, notably slowing commodity demand from China, Mongolia’s principal customer, as it moves into a less commodity intensive phase of development. Chinese imports of coal and copper, Mongolia’s key commodities, are already growing at a much slower pace than in 2009-10 (Chart 13).


PNG's election beats expectations

The recent election has raised hopes of a relatively stable government and return to normal politics.

It has enabled Peter O’Neill to form a coalition with several parties, including that of his former rival, Sir Michael Somare, and some independent MPs. In all, 94 MPs are in the coalition – in a 111- seat unicameral parliament. O’Neill’s party, the People’s National Congress (PNC) holds 27 of the seats. O’Neill himself was sworn in as prime minister on 3 August (Chart 14).

There are three developments to note – the comparative lack of violence during polling, the reconciliation between O’Neill and Somare, and the sidelining of former deputy prime minister Belden Namah.

  • Poll violence. What was anticipated to be a violent poll has actually turned out quite peacefully. There were early reports, particularly from the Highlands, of gunfights at polling stations and stolen empty ballot boxes being returned full of ‘votes’. But the incidence has been nothing above the usual.
  • O’Neill/Somare reconciliation. The two men fell out after O’Neill replaced Somare as prime minister last August. Right up to the election, the Somare camp was using everything it could, including court challenges, to unseat O’Neill. But with the legitimacy O’Neill has gained from the election, it has evidently chosen to side with the victor and Somare appears to be focused on provincial affairs as the Governor of East Sepik Province.
  • Namah sidelining. Despite helping to unseat Somare a year ago, Namah turned against O’Neill during the election campaign and made it plain he wished to become prime
    minister. In the immediate aftermath of the election he was urging MPs to desert the O’Neill camp. Namah has not been awarded a cabinet post.

O’Neill has named a 32 man, 1 woman cabinet. Don Poyle, leader of the second largest party in parliament, the Triumph Heritage Empowerment (THE) Party, is the Treasury Minister. A more junior member of Poyle’s party, Leo Dion, was named Deputy Prime Minister. William Duma has been returned as Minister for Petroleum and Energy, and Byron Chan as Minister for Mining.

These two, together with Polye, will have the job of managing the mining and LNG boom. Last year, Byron Chan pushed for legislative changes to give greater control of natural resources to landowners and provincial governments.

The election has taken place against an economic backdrop of strong, if declining, growth, falling commodity prices, and fiscal deterioration. According to the Asian Development Bank, real GDP is on course to grow at 7½% this year, before slowing next year as LNG construction and mature mining and oil operations all scale back. Prices of PNG’s key commodity exports have also declined recently – copper, gold, logs, cocoa, coffee, palm oil and copra. These price declines could push the 2012 national government budget into an equivalent to 1½ % of GDP from the balance initially planned. Neither the ADB, nor the IMF consider this to be a problem in itself, but do warn of longer run fiscal solvency problems if the income tax base isn’t broadened and tax compliance and service delivery aren’t improved.

Somare and Namah could try to undermine O’Neill, so the judgments above will need to be kept under close review. But the outcome so far appears to be better than the one being forecast before the election.


Investor pact aims to thicken Taiwan-China ties

An investor protection agreement between China and Taiwan should encourage cross-Strait foreign investment. The agreement, signed earlier this month, is the first major initiative under the Economic Cooperation Framework Agreement, a cross- Straits free trade agreement signed in 2010.

The agreement aims to give assurances to both Taiwanese investors on the Mainland and Mainland investors in Taiwan, but its practical import will be mainly for Taiwanese companies, since they are major investors in China, and there have been many incidents in which Taiwanese people have lost assets or even been arrested after disputes with Mainland partners or authorities. Under the agreement, they will be able to seek arbitration on disputes in Taiwan and Hong Kong, rather than only within Mainland courts. In addition, authorities in both China and Taiwan will be obliged to
notify family members or companies of detained suspects and to allow for visits by both family members and lawyers. The agreement may also establish Taiwan as a gateway for other countries to invest in the Mainland if it turns out to provide effective protection for investors.

Brazil's economy stalls

A sharp slowdown reflects home grown challenges as well as difficult international conditions.

Brazil’s economy barely expanded in the March quarter (Chart 15), reflecting a slowdown in fixed asset investment. The economy is expected to grow by less than 2% this year, something of a letdown after the country sailed through the 2008-09 crisis largely unscathed and chalked up growth of 7½ % in 2010.

Slower international growth is partly to blame, especially in Brazil’s top trading partners, China, the US and Europe, as is the resulting softness in commodity prices. It also hasn’t helped that consumers are turning cautious after a spell of brisk spending.

But this isn’t the whole story. The third consecutive quarter of weakness in the world’s sixth-largest economy is also traceable to ‘supply-side’ inadequacies. A combination of infrastructure, an expensive and underqualified labour force, and regulatory red tape have raised the costs of doing business and discouraged companies from launching expansion plans. Business and investor complaints about red tape dovetail with Brazil’s disappointing rankings on the World Bank’s ‘ease of doing business’ indicators, particularly in relation to ‘paying taxes’, ‘enforcing contracts’ and ‘starting a business’ (Chart 17). There has also been a sharp increase in unit labour costs (Chart 16).

It isn’t all bad news, though. On factors that matter most to foreign investors, such as protecting property rights and controlling corruption, Brazil compares favourably with its regional peers, although much less favourably with OECD countries (Chart 17).

Moreover, there are hopes that the infrastructure bottlenecks will be reduced following President Dilma Rousseff’s recent announcement of a roughly US$66 billion infrastructure program. Most of the money – roughly US$50 billion – will come from selling rights to private companies to operate road, rail and other assets. The first stage will be the sale of rights to operate 7,500km of roads and 10,000km of railways. Funding will also be provided by BNDES, the national development bank. The majority – almost three quarters – of the money is scheduled to be spent over the next five years. The plan has been received favourably by many commentators, although there are some reservations about the government’s ability to execute.


Argentina tightens the screws

Argentina is continuing to tighten exchange controls as the economy stalls.

New changes to the civil code are pending that will force the settlement of peso-denominated debt at the official exchange rate. These proposals come on top of a range of measures introduced since October 2011 that have progressively tightened access to foreign currency. These measures include: controls on foreign exchange purchases by Argentines travelling abroad, longer approval processes for businesses to buy imported inputs or final goods, and curbs on people converting their savings from pesos into dollars.

Far from obstructing outflow, the exchange controls are actually encouraging more outflow, because holders of US$ bank deposits are withdrawing funds out of fear they will be seized – US$ deposits dropped by 16% in June. The wedge between the official and unofficial exchange rate has widened sharply (Chart 18), which points to a potential sharp peso depreciation.

The currency restrictions are exacerbating the country’s economic woes. A range of official indicators – a composite economic activity index, an index of construction activity, industrial production and consumer confidence – all point to a decelerating economy. For example, according to the government’s monthly economic activity index – a close proxy for GDP – economic activity fell 0.5% in May yoy, the first contraction in 34 months. Similarly, industrial production fell 4.7% yoy in June, the biggest decline since January 2009. At the same time, inflation remains high – private estimates put it at 24% a year. And despite the imposition of currency and import restrictions, the country continues to record current account.

There has been speculation, denied by the government, that export tariffs on soy beans could be hiked to 40% (from 35% now) to capture a bigger share of export revenues. Argentina is one of the world’s largest producers of soy beans, and its exporters have been receiving a windfall thanks to soaring soy bean prices caused by drought in the US. The anti-government newspaper El Cronista Comercial estimates that a 5 percentage point hike in the tariff would see the government capture three quarters’ of the income generated by Argentina’s top cash crop (including income tax payable by farmers).


Mining roundup - Colombia, Zambia, Peru, Bolivia, South Africa and Indonesia

Investment climate risks are hampering mining companies in Colombia, Zambia, Peru, Bolivia, South Africa and Indonesia.

In Colombia, FARC rebels have bombed the railway line at Cerrejon, Colombia’s largest open pit coal mine, owned by a joint venture that includes BHP Billiton. The incident is the latest in a series of FARC attacks against the mining industry and coincides with a strike at the country’s main coal railway, Fenoco.

In Zambia, a Chinese mine supervisor has been killed during a strike at the Collum mine south of Lusaka. Chinese mines in Zambia have a history of disputes with their workers over pay and conditions. The president, Michael Sata, threatened to expel Chinese investors while an opposition leader, though as president he has welcomed Chinese investment. The most recent incident at the Collum mine isn’t the first: several workers there sustained injuries during a strike in 2010 (though prosecutors have dropped charges against two Chinese managers who allegedly shot the miners). The most recent dispute at Collum was over the payment of the minimum wage. Most mines in the northern Copperbelt don’t have this issue to contend with, because they reportedly pay above the minimum wage.

In Peru, Newmont Mining Corporation is facing protests at its Conga gold mine that have killed five people. The president has declared a state of emergency in the area in response. There are few signs the dispute will be settled quickly.

In Bolivia, the government last month revoked the rights of Canadian company, South American Silver, to the Malku Khoto mine. That same month, India’s Jindal Steel and Power walked away from plans to invest $2.1 billion in an iron ore mine, blaming the government’s failure to deliver on power supply agreements. The company had reportedly already invested US$100 million in the mine. In June, a licence held by Glencore over its Colquiri tin and zinc mine was revoked. All three companies are seeking compensation. Bolivia was ranked the third most difficult place for miners to do business in the 2011-12 Fraser Institute’s survey of mining companies.

In South Africa, the shooting by police of striking miners at Lonmin’s Marikana platinum mine reinforces the socioeconomic challenges faced by South African mining companies.

Finally, in Indonesia, Australian company, Intrepid Mines, has recently been ejected from the Tujuh Bukit mine in Java by its local partner. The Brisbane-based, Toronto-listed company has reportedly spent US$95 million on the gold-silver-copper mine in Java. On face value, it looks as if this might be a shareholder dispute. Nevertheless, it does highlight the risks companies face when operating in jurisdictions with challenging investment climates.

Another company that appears to have been affected by such risks is British company, Churchill Mining. After announcing the discovery of considerable coking coal in Kalimantan, its mining permit
transferred to a local company. Churchill has turned to international arbitration – specifically ICSID, or the International Centre for the Settlement of Investment Disputes – after the Indonesian Supreme Court rejected its appeal against the transfer. It is reportedly seeking US$2 billion in compensation. The Indonesian company to which Churchill’s permit was transferred claims licences it once held over the area are still valid.

In the background, resource nationalism is rising, ahead of presidential elections due in 2014. Although a 2009 mining law allowed 100% foreign ownership of mines, three more recent regulations water this down – one obliging foreign investors to sell 51% of their shares to Indonesians after 10 years of operation; another directing minerals to be processed in Indonesia after 2014; and a third imposing a mineral export tax of 25%, increasing to 50% in 2013, ahead of the 2014 ban on unprocessed mineral exports.

Roger Donnelly, Chief Economist

The views expressed in World Risk Developments are Export Finance Australia’s. They do not represent the views of the Australian Government. The information in this report is published for general information only and does not comprise advice or a recommendation of any kind.  While Export Finance Australia endeavours to ensure this information is accurate and current at the time of publication, Export Finance Australia makes no representation or warranty as to its reliability, accuracy or completeness.  To the maximum extent permitted by law, Export Finance Australia will not be liable to you or any other person for any loss or damage suffered or incurred by any person arising from any act, or failure to act, on the basis of any information or opinions contained in this report.