World Risk Developments June 2012


Greek election prolongs uncertainty

The victory of the centre-right New Democracy party in Sunday’s general election has damped fears of an imminent euro area exit, but kept alive doubts about Greece’s continuing adoption of the euro – and indeed the euro area’s longer run survival.

The market’s worst fear was a victory by the far-left Syriza coalition because Syriza had threatened to ‘tear up’ the MOU with the troika. In that event, the troika had said it would cut off further bailout funding. And without such funding, the government had calculated it would ‘run out of money’ by July 20. To make matters worse, there was also the possibility that the European Central Bank (ECB) would halt its liquidity support of Greek banks.

The risk thus arose that

  • starved of cash, the government could repudiate its debt and issue IOUs to public servants and suppliers
  • depositors would make runs on banks the government would respond with bank holidays and capital controls
  • the turmoil would spill across borders into other vulnerable countries in Peripheral Europe
  • other governments with bailouts – Ireland and Portugal – could seek to renegotiate their terms
  • the turmoil would also reach the Core of the EU, because the debt repudiation would erode the solvency of the EU’s rescue fund, requiring Core taxpayers to recapitalise it, and also hit the ECB
  • the Greek government could be tempted to redeem its IOUs in drachmas – thus sleepwalking out of the euro area, even though it had avowedly wished to stay within it.

The New Democracy victory appears to head off such a meltdown. Neither the New Democrats nor their likely coalition partner, PASOK, want to tear up the MOU; they merely want to renegotiate it – to moderate the austerity it demands. In return, the EU and Germany have said that they could consider extending the time over which the country delivers its austerity. They are, however, insistent that austerity is necessary and must remain.

There seem to be four courses that events can now take: first, the adjustment program gets back on track and succeeds (in restoring fiscal and banking solvency and growth); second, the adjustment program gets back on track but doesn’t succeed; third, the two sides fail to reach agreement on new terms; fourth, the EU changes its whole approach to crisis management by placing a greater stress on symmetrical and growth-oriented adjustment.

The first course seems unlikely: as we argued in our May newsletter, austerity isn’t working. The second and third courses seem more likely. This means that the risk of an eventual Greek debt repudiation and exit from the euro area plus attendant contagion’ remains considerable.

The fourth course seems unlikely at this stage, but could be a stabiliser. EU leaders are reportedly going to do a big re-think at their forthcoming summit on June 28. The trouble is, forming a consensus around a new approach could prove difficult – as we discuss in the next story.

Spain gets a bailout ...

EU leaders announced on 9 June that they will lend Spain up to €100 billion to recapitalise its failing banks.

This makes Spain the fourth and largest euro area economy to get EU help – behind Greece, Ireland and Portugal – though Cyprus could soon be No 5 – see next story.

Events have moved quickly. In February the government insisted that it didn’t need to inject any more state money into the banking system (on top of the €34 billion it had already provided, about
half which it had recovered). But then on 9 May it part-nationalised the country’s largest real estate lender, Bankia, by converting a €4.5 billion government loan into equity. It injected another €19 billion of equity (about 2% of GDP) on 25 May. At the same time, the deputy prime minister insisted that her government would ‘absolutely not’ seek aid from Brussels for further bank rescues. But on 9 June the economy minister announced that the government did indeed intend to seek ‘European financing’ for its banks. Whereupon the ‘Eurogroup’ stated that it would ‘respond favourably to such a request’.

As the IMF has noted in a recent review, the banking system is suffering from a crisis ‘unprecedented in its modern history’, brought on by ‘the bursting of a real estate bubble after a decade
of excessive leveraging’. It suggests that the system might need another €46 billion-73 billion of capital to stay afloat. Market estimates of the recapitalisation need are mainly in the €60 billion-100 billion range.

Will the support solve Spain’s crisis? And put an end to the crossborder contagion? Neither is assured.

Disappointingly, the support won’t go directly to the banks: the euro area’s bailout rules forbid this. The funds will instead be channelled through the government’s books, potentially adding as much as 20% to public debt, which is unsettling financial markets. Bond yields yesterday crossed the important psychological threshold of 7% as a result. (Actually, EU leaders will discuss at a summit on June 28-29 whether their new permanent bailout fund, the European Stability Mechanism, can be allowed to lend directly to banks. But the largest shareholder, Germany, is strongly opposed.)

So there is a question mark over whether the rescue will solve one of the key underlying problems of the Periphery: the dubious solvency of banks and governments – an inter-connected problem.
But it also won’t tackle the other problem: uncompetitiveness. The official answer to these twin problems is emergency financing (but not debt relief); fiscal austerity; structural reform; and
‘internal devaluation’. But as we argued last month, these policies aren’t working: the Peripheral economies continue to stagnate or slump, competitiveness is only inching up, and public debt/GDP
ratios continue to rise. As a result, banks and governments remain prone to capital strikes, runs and cross-border spillovers – and governments to the temptation to seek debt relief and leave the
euro area. Which means the covenant-light bank bailout may soon have to be turned into a full sovereign bailout.

To be fair to EU policymakers, they have noticed – and begun to talk about area-wide infrastructure spending and even higher wage and price inflation at the Core than at the Periphery, to help the Periphery export its way back to growth and solvency.

The end-June summit will also reportedly look at ways to achieve greater integration on the grounds that tightly integrated federations, such as the US, Canada, Switzerland and Australia, don’t fall apart whenever one or more of their constituents come under strain. The options to be considered apparently include a banking union, a pan-European bank deposit guarantee and public debt mutualisation.

But these measures are controversial particularly in the influential Germany. So it remains uncertain whether they will be implemented decisively enough to restore market confidence and keep the euro area together.

... and Cyprus could be next

Cyprus is widely expected to be the next country to apply to the EU for a bank bailout.

There are two parallels with Spain. First, the government initially denied that it would need a bailout, but has recently been coming out of denial, fast. In its latest calibration, the president said on June 1 that while he didn’t take a bailout ‘as a given’, nor did he want ‘absolutely to exclude it’. Second, the banking system has been hit by a property bust.

But unlike Spain, the island’s banks also have large exposure to Greece. In December 2011, the three main banks had lent €23 billion to the Greek private sector, and held €15 billion worth
of deposits for Greeks. Cypriot banks also have relatively large Greek sovereign exposures. According to the European Banking Authority, the two Cypriot banks included in an EU capital exercise had €4.9 billion of Greek sovereign exposure in September 2011 – representing almost two thirds of their total sovereign exposures and more than 100% of their core Tier 1 capital. The second largest bank, Cyprus Popular Bank (CPB), has been forced to write off €2.3 billion in Greek government bonds. This has reportedly wiped out its entire core Tier 1 capital.

So the questions that have arisen are, How to recapitalise CPB? And are other banks vulnerable? There is a plan to recapitalise CPB with a €1.8 billion rights issue, but this could prove difficult to execute, because the bank’s market capitalisation has fallen to almost nothing – €125,000 in early June.

The government has already lost market access and been downgraded to junk status. It has only been able to avoid an EU bailout so far by borrowing €2.5 billion from Russia to cover about €2.7 billion of debt falling due in 2012. It is currently in the throes of an austerity program featuring public sector pay restraint and pension reform, means testing of social transfers, and a two point rise in the VAT rate from 15% to 17%. But it is struggling because the economy is shrinking.

The nightmare scenario is a Greek exit from the euro area. This would trigger a full-blown crisis in the Cypriot banking system.

To prepare for such an outcome, some Cypriots have been urging acceptance of an EU bailout without delay. Others, however, note that there will be strings attached. They worry that Brussels could direct Nicosia to raise the 10% corporate tax rate, currently the lowest in the euro area – even though Ireland was allowed to maintain its 12½% rate after receiving a bailout. The 10% corporate tax rate has been credited with attracting many professional, scientific and technical services firms to Cyprus.

China and India slow to below - trend growth

The latest OECD composite leading indicators signal that growth in China and India is slowing to below trend. In recent years, ‘Chindia’ has been a key driver of world growth and Australian exports.

The composite leading indicators (CLIs) – designed to anticipate turning points in economic activity – signal that economic activity in the US and Japan is improving, although the growth rate may be moderating (Chart 1). In contrast, the CLI for the euro area points to below-trend activity, although it doesn’t suggest that activity will collapse.

Perhaps of greater concern for Australian exporters is that the CLIs suggest that China and India are slowing to a below-trend pace (Chart 1, RHS). This is consistent with recent official data. In China, growth in fixed asset investment, retail sales and industrial production have all eased noticeably in recent months (Chart 2). Chinese fixed asset investment grew by 20% year-on-year in May – the slowest rate since 2001. Meanwhile, Indian GDP growth was 5.3% year-on-year in the March quarter – a nine-year low.


China is Australia’s No 1 export market, and India No 4, buying between them nearly a third of total exports.


Commodity prices to fall , but remain high

The World Bank expects prices for most commodities to fall over the next five years, but remain high compared to historical averages.

The Bank’s latest forecasts, completed this month, show prices for most commodities falling over the next five years, but remaining well above historical averages in both nominal and real terms (Chart 3). Apart from softer demand growth, the price falls reflect rising supply, with the prolonged period of sky-high prices over 2003-11 encouraging substantial investment in new capacity. The one exception is aluminium, where prices are expected to rise over the forecast period – current prices are at or below marginal costs for many producers.


According to the Bank, the main downside risk to its forecasts is a further deterioration in world economic conditions. A sharper than- expected slowdown in China would have a particularly large impact, because China consumes nearly 43% of metal production and nearly 50% of coal production (Chart 4). It also consumes around 60% of the iron ore traded in the seaborne market.


Politics threaten Thailand’s economic rebound

Government plans to rehabilitate Thaksin Shinawatra and alter the country’s constitution threaten to provoke more street protests.

The Thai economy bounced back strongly in the March quarter of 2012 from last year’s floods, growing by 11% (on a seasonally adjusted, quarter-on-quarter, but non-annualised basis), after contracting by almost 9% in the year to December 2011. The rebound was helped by government spending on flood control and increases in the minimum wage, graduate salaries and incomes for farmers.

With the economy now recovering, the government of Prime Minister Yingluck Shinawatra, younger sister of exiled former prime minister Thaksin Shinawatra, has turned its attention to passing reconciliation legislation that may exonerate Thaksin.

Pro-government parliamentarians say the law will help ease tensions stemming from six years of political conflict. The aim is to give an amnesty to anyone convicted of political charges between 2005 and 2010. Although the proposed laws are designed to apply equally to the opposition People’s Alliance for Democracy (so-called‘yellow shirts’) and the government and its sympathisers (‘red shirts’), the most notable could be Thaksin, who was deposed as prime minister in a military coup in 2006.

In addition, the government is seeking to alter the constitution to remove protections for members of the military-backed governments that ruled after the 2006 coup. One of such governments established the 2008 corruption investigation that led to Thaksin’s conviction.

Both these moves are threatening to trigger another round of economically damaging street protests. Already around 1000 red shirts took to the streets on 7 June, rallying outside parliament to gather signatures for a petition demanding that legislators impeach members of the Constitutional Court who halted further parliamentary debate on the constitutional changes. A much larger ‘red shirt’ protest is reportedly planned for 24 June.

If tensions escalate further, the economic toll could be high. Important investors are already scaling up their operations in neighbouring countries, such as Malaysia, to flood-proof their supply chains. Further political violence could become another excuse to shift production and procurement abroad.

Burma reaps a democracy dividend

Looser sanctions will make life easier – if still tough – for western investors.

As we noted in April, democratisation in Burma has prompted some countries, including Australia, to ease sanctions on the country. Australia recently went further, announcing that it would lift all
remaining travel and financial restrictions against Burma and double aid flows to the country by 2015. Meanwhile, Washington decided to suspend its investment restrictions last month and the EU to suspend in April all of its sanctions for a year. Australia, the US and EU all retain arms embargoes.

The lifting of sanctions will help to restore more normal commercial relations, as will the government’s recent floating of the currency, which has simplified the country’s formerly complicated multiple exchange rate system under which public and private sectors used different rates. Western business reportedly sees much potential – untapped resources, a large and young population, and strategic location, notably southern coastal access and borders with India, China and Thailand. Still, despite these advantages, the country remains desperately poor – per capita income is around US$800 a year, one of the lowest in the region; Thailand’s per capita income is roughly US$5000, by comparison.

Moreover, western investors may face considerable competition from their Asian peers, many of whom already either operate in Burma or have been scouting opportunities. Last but not least, the business climate is difficult – Burma ranks at, or close to, the bottom of World Bank ‘governance’ league tables (Chart 5) and its infrastructure is poor.


Investors are reportedly awaiting the introduction of a foreign investment code that will offer strong incentives to set up in the country. It was to have been released in February, but now looks
likely be delayed until the next parliamentary session, perhaps in August. In the meantime, investors will be subject to an existing 1988 foreign investment law, stemming from a previous ‘open door’ policy holding sway in the late 1980s and early 1990s.

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.