World Risk Developments May 2012


Backlash against Euro area austerity

Faced with growing evidence that austerity isn’t resolving the euro area crisis, voters and politicians alike are casting round for new solutions.

Stagnation. The evidence for the failure of austerity is of three types. First, output continues to stagnate below its pre-global financial crisis peak; the area as a whole is likely to re-enter recession this year (Chart 1). Second, governments at the Periphery and banks throughout the area continue to face funding difficulties, despite a €1 trillion injection by the European Central Bank of cheap three-year loans into banks zone-wide (Chart 2). The problems of Spain have become especially acute over the past month. Third, austerity is failing to strengthen fiscal solvency – public debt/GDP ratios in all the troubled Peripheral countries continue to rise, despite severe public spending cuts and tax increases, and even the Core countries of France and Holland find themselves in breach of the EU deficit target of 3% of GDP (Chart 3).

The overall unemployment rate in the euro area is now 11%, and youth unemployment is around 50% in both Greece and Spain (Chart 4). Not surprisingly, voters are angry – and casting round for new politicians with new solutions.


Backlash. The backlash started in Holland last month, when the far-right Freedom Party of Geert Wilders withdrew its support from the minority coalition government of Liberals and Christian Democrats, causing it to collapse. The Freedom Party’s decision was in protest at a package of measures designed to reduce the budget deficit to the EU target by 2013. Then came François Hollande’s victory in the French presidential election on May 6, and the defeat of the traditional ruling parties in the Greek general election the same day. The rise of rejectionists in these three countries is likely to have several implications for the euro area – some centrifugal, some centripetal. Take the centrifugal forces first.

Greece. The probability of another Greek sovereign debt default and of Greek exit from the euro area have both increased. Ironically, the key Greek rejectionist party, Syriza (Left Coalition), wants only to soften the terms of Greece’s bailout agreement with the troika, not leave the euro area. But if it gets its way, and unilaterally modifies the bailout terms, the troika could react by withholding funds. The Greek government could in turn respond by imposing a moratorium on debt repayments. But it is still running a primary budget deficit – a deficit even after subtracting public debt interest payments. So in the face of a stoppage to bailout funds, it would need to limit its spending to its smaller revenue, or in other words, impose even more of the fiscal austerity that it is seeking to avoid.

In such a bind, it could elect to readopt the drachma, emboldened by the stories of other countries that staged rapid exported recoveries after financial crises thanks to sharp currency depreciations – Iceland, Argentina, Russia, Korea, Indonesia.

Spain. Rejectionism also increases risks for Spain. Even before the French and Greek elections, interest rates on Spanish government debt had been rising, as bond markets became increasingly nervous about Spain’s need for a bailout. Their worries stemmed partly from the familiar concern that the government was struggling to stabilise debt in a shrinking economy. They also had to do with the inadequate capital positions of Spanish banks hit hard by the bursting of the country’s property bubble – something the market suspected the government would have to rectify with
bailouts. Sure enough, the government earlier this month was forced to convert a €4.5 billion convertible bond into common equity at the fourth-largest bank, Bankia.

Spanish public debt is projected to increase from 69% of GDP in 2011 to more than 80% by 2013, even before any bank bailout. But it will balloon even more if, as seems likely, the government has to provide further bailouts. In fact, it may not be able to borrow all the money it needs to fund its debt maturities and deficit plus bank bailouts, forcing it to go cap in hand to the troika.

In this fragile situation, it is easy to see how a rising risk of Greek default and euro area exit makes bond markets even warier than they already are of funding Spain, which brings on a self-fulfilling crisis. A related worry is that the current ‘bank walk’ – or slow withdrawal of deposits from Peripheral banks – becomes a wholesale bank run.

Political confrontation? The French and Greek elections also raise the threat of confrontation between ‘austerians’ like Germany and the EU bureaucracy on the one side and ‘expansionists’ like Hollande, and probably the government that eventually emerges in Greece, on the other.

The new French president has indicated that he will renegotiate the fiscal compact treaty signed, though not yet ratified, by 25 EU countries. Under this compact, the brainchild of Germany, countries promise to limit their overall deficits to 3% of GDP and their structural deficits to ½% – or face automatic sanctions. Hollande is reportedly seeking either a separate ‘growth pact’ or an addendum to the existing treaty providing for: a financial transaction tax, use of EU structural funds to promote growth, redirection of European Investment Bank (EIB) financing towards job creation, and creation of ‘project eurobonds’ to finance industrial infrastructure.

The most immediate cause of friction is likely to be a request by Hollande for more time to reach deficit reduction targets. This could encourage other countries struggling to meet their targets such as Portugal to follow suit. Such requests could bring fiscally challenged member states into conflict with the European Commission, which polices the compact.

Turning to the centripetal forces, two recent developments give some cause for hope.

Growth pact. The austerians have indicated that they would be prepared to accept a growth pact running parallel to the fiscal compact. The German foreign minister, Guido Westerwelle, recently said that his government would work with France on such a pact. ECB President Mario Draghi has also lent his support, while EU Economic and Monetary Affairs Commissioner Olli Rehn has argued for publicly funded infrastructure projects to reduce unemployment.

Rehn and European Commission President Jose Manuel Barroso have said EU leaders might soon announce a €10 billion increase in capital for the EIB, raising its lending capacity by €60 billion. Further investment could come from unused EU structural funds of €82 billion, ‘project eurobonds’ and front-loading of infrastructure spending in the forthcoming EU budget – in other words, a package similar, if not identical, to Hollande’s. Rehn has also suggested that EU budget deficit reduction targets could be relaxed, though not for countries most in need – bailout recipients (Greece, Ireland and Portugal) and those seeking to avoid bailouts (Spain and Italy).

German inflation tolerance. The other positive development for ‘growth-oriented adjustment’ is an indication from Germany that it can tolerate more inflation. Earlier this month, Finance Minister Wolfgang Schäuble lent his support for German wage increases to boost consumer demand and inflation, and thereby help troubled Peripheral Eurozone countries restore international competitiveness. In addition, Bundesbank President Jens Weidmann has told the Bundestag, the lower house of Germany’s parliament, that he would be prepared to see German inflation run higher than the euro area average as part of an area-wide adjustment process.

Conclusion. The backlash against austerity is raising risks of contagion and euro area disintegration, but also encouraging politicians to promote growth-oriented adjustment. It may even prod the ECB into unleashing its Big Bazooka – in other words, acting a lender of last resort to beleaguered governments – which would be a big stabiliser. It is not clear which tendency will prevail – another way of saying that uncertainty has increased.

Looming US LNG exports

Potential US gas exports do not represent a big threat to Australian LNG projects currently under construction. But this could change if there are large cost overruns at the Australian projects, or technological improvements significantly lower the long-run break-even price of US shale gas deposits.

A large wedge has opened up between LNG prices in Asia and gas prices in the US (Chart 5). In April 2012, the difference between the Japanese LNG price and the US gas price was $14/mmbtu. The Asian gas price has risen in response to two things: a jump in Japanese demand — with gas-fired power stations helping to offset lost nuclear capacity — and high oil prices. Meanwhile, the collapse in the US gas price reflects a surge in domestic gas production, driven by a shale gas ‘revolution’ that has made feasible the extraction of vast reserves of unconventional gas in the US and Canada.


With such a large price differential having opened up, LNG exports from North America to Asia have become financially attractive. This has fortified the backers of several LNG export
projects in both the US and Canada. The US Energy Information Administration now expects that the US will become an LNG exporter after 2015, as a few of these projects come on stream (Chart 6). How times change. As recently as 2005, the EIA expected the US would become a significant LNG importer.


This likelihood of US exports has raised the possibility that exports to Asia from planned Australian LNG projects could be displaced. But this risk seems small. First, the EIA expects that the US will be only a small LNG exporter. Second, US prices are expected to rise from current lows, reaching US$4-5/mmbtu by 2016. At these prices, and after adding in liquefaction and transport costs, the commercial breakeven price of US LNG landed in Asia would be similar to the average breakeven price of Australian LNG projects under construction, currently around US$8-10/mmbtu. This suggests that even if US exports are significant, North American LNG would only cap prices in Asia and lower regional price differentials, not displace the average new Australian supplier.

The key risk to this conclusion is Austrailan construction costs. The large expansion of Australian LNG export capacity is placing strain on labour markets and infrastructure, which may push up capex costs and move projects further up the world LNG cost curve. Cost overruns also generally imply project delays; delays that could trigger re-negotiation clauses in supply agreements, exposing projects to price and buyer risk at a time when alternative sources of gas are more plentiful.

Historically, cost and time overruns in the LNG sector have been a frequent occurrence. Of the LNG projects completed over 2000-2010, JP Morgan estimates that 34% were delivered behind schedule and 38% were over budget (Chart 7).


The conclusion that US shale gas is not likely to be a dramatically cheaper alternative source of LNG for Asian buyers is also based on forecasts of the long run US domestic gas price. The domestic
price of US$4-5/mmbtu by 2016 is based on the forward curve – contracts for future gas delivery are traded on the Chicago Mercantile Exchange. Similarly, the EIA predicts that the Henry Hub benchmark price will rise to around US$4.70/mmbtu in 2016. Part of the rise is based on the fact that the current low price is below the breakeven price of many wells in the US.

Still, shale gas extraction technologies are rapidly improving, making it difficult to confidently predict the long-run breakeven prices of US shale deposits and the level of recoverable reserves. This raises the risk that long run US gas prices could fall below US$4-5/mmbtu and the amount of exportable gas could correspondingly swell.

The net result? US shale gas would become a more compelling alternative source of LNG supply to Asian buyers, even to those concerned about the security of supply and volatility in the Henry Hub price.

SME exporters in a high A$ world

Australian small and mid-sized exporters are struggling under the weight of the high Australian dollar. They are mostly in the slow lane of the three-speed economy, the non-mining sector, where demand has been flagging.

While exporters in the manufacturing and service sectors are battling to maintain competitiveness in the face of the high Australian dollar, resource exporters have done well: despite a roughly 20% increase in the value of the Australian dollar since 2006 their sales have more than doubled (Chart 8).


Why is one group struggling while the other prospers? Basically, because the resource exporters have been benefiting for higher international commodity prices, which has compensated for the
strong dollar, whereas manufacturing and service exporters have had to contend with far less buoyant and sometimes even declining world prices.

Unfortunately, for SME exporters, most are in the non-mining sector – the so-called slow lane of the economy (Chart 9). As Chart 1 shows, manufactured and service exports (tourism, education and business services) have flagged as the dollar has risen.


Many of the industries in the slow lane are in the southern states. Western Australia, Queensland and the Northern Territory account for nearly 90% of mining exports. But half of Australia’s manufactured exports and 70% of its service exports come from the southern states.

With China expected to continue growing rapidly, most analysts predict that the dollar will remain high compared to its 75 US cent post-float average. In this environment, SME exporters may need to re-evaluate their business strategies, perhaps by taking advantage of lower Australian dollar prices for imported inputs and capital equipment, focusing on providing inputs and services to the resources sector, and taking a hard look at their international supply chains.

The challenges facing SME exporters are broader than the value of the Australian dollar. Other difficulties include lack of scale in certain markets, vigorous competition from cheap Asian imports, and sluggish growth in traditional export markets in the North Atlantic.

None of these challenges will disappear if the dollar falls. Indeed, a world in which the Australian dollar is substantially lower would probably be one with much lower terms of trade and diminished
growth prospects, probably the result of a significant slowing in China, Australia’s No 1 export market.

Dubai ’s economic recovery

The debt overhang from Dubai’s borrowing binge now appears to be shrinking as a number of government-related entities (GREs) successfully strike restructuring agreements with their creditors. Such successes are helping to rekindle investor interest in Dubai –a recent US $1.25 billion, two-tranche sukuk from the emirate was more than 3½ times oversubscribed.

Dubai’s relatively swift return to international debt markets seemed doubtful back in November 2009 when it announced a debt standstill for creditors of state-owned Dubai World and confirmed it would provide no support to the emirate’s extensive web of GREs.

But Dubai didn’t stay out in the cold for long. Less than a year after announcing the standstill, it successfully issued a US$1.25 billion sovereign bond and the government-owned Emaar Properties issued a US$500 million convertible bond, albeit at relatively high yields – 6.75% for the 5-year tranche and 7.875% for the 10-year tranche. The most recent debt issue was significantly cheaper – 4.9% on the 5-year and 6.45% on the 10-year.

How did Dubai manage to achieve such a swift turnaround? Part of the reason lies in its approach to debt restructuring. It has followed what has increasingly come to be called a ‘4B’ strategy – bail out bondholders, burn the banks – in which it has maintained sovereign bond payments and forced the bulk of the restructuring onto banks, both local and international, that lent to the GREs.
The strategy has been painful for the banks involved but highly successful for Dubai, which has restructured around US$22 billion of its US$36 billion of problem debts. This has helped to restore Dubai’s creditworthiness, allowing GREs to return to the capital markets.

Successful debt restructurings by GREs are not the only reason for the renewed investor interest. The tourism industry is booming — Dubai attracted 9.3 million visitors in 2011, 10% up on 2010 levels
— and trade, retail and manufacturing have also picked up. Superior infrastructure and a strategic location between Asia and Europe are some of the underlying ‘pull factors’ behind the activity. The
infrastructure includes Terminal 3 at the international airport, the largest terminal in the world, which serves as Emirates Airline’s hub. Dubai International is the fourth-busiest international passenger and freight airport internationally, handling over 50 million passengers a year. The government will probably continue to invest in the airport’s expansion – a senior Dubai official indicated that the proceeds from the $1.25 billion sukuk would be used to fund the expansion of Dubai International Airport.

Despite all this buoyancy, property will remain the lagging sector for a while. Prices continue to stagnate (Chart 10) and the financial sector remains weak. Bank profits continue to be affected by the high level of provisions for debt-ridden GREs, which in turn has affected lending – lending in the UAE grew by only 2% in the year to February 2012.

In addition, about US$15 billion in GRE debt repayments fall due in 2012, including a US$1.25 billion sukuk by Dubai International Financial Centre Investments (DIFCI) – the investment arm of the Dubai International Financial Centre – due in June 2012 and a US$2 billion sukuk by Jebel Ali Free Zone maturing in November 2012. Both entities will need to refinance the bulk of their debt payments without strong cash flows and in an increasingly uncertain global funding environment.


Nevertheless, a recovery is definitely underway. And given Dubai’s past success in debt restructuring, there is a strong chance that the GREs will successfully refinance their outstanding debt in 2012.

India’s investment grade under threat

Slowing growth, large fiscal, persistent inflation and stalling reforms are starting to challenge India’s status as a rapidly emerging economic superpower.

In December 2011, Indian GDP growth slowed to 6.3% yoy. Investment has been particularly lacklustre and is falling in year ended terms (Chart 11). Moreover, despite the slowdown, inflation is stubbornly high and the current account wide — reaching 4% of GDP over the year to March 2012.


Highlighting the change in India’s outlook, rating agency Standard and Poor’s placed a negative outlook on India’s BBB- debt rating in April. According to the agency, there is now a 1-in-3 chance that it will downgrade India’s debt to ‘junk’ in the next two years. This runs against the trend of rating upgrades elsewhere in Asia. Markets are also clearly concerned: the rupee is down by 20% against the US$ over the past year to be at record lows (Chart 12).


Apart from the slowdown, S&P points to India’s sizeable fiscal and large debt overhang as reasons for the darker outlook (Chart 13). It also believes that only modest fiscal and business sector reforms will be achieved before the 2014 elections due to ‘political gridlock’.


In recent years, scandals and infighting within the coalition government, led by Prime Minister Manmohan Singh, have obstructed the reform drive. This was highlighted in November 2011 when a long-awaited decision to allow foreign investment in retail was reversed within days, due to a backlash from domestic retailers and some coalition members.

More recently, business confidence has been dented by proposals to tighten tax regulations on foreign investment. The government aims to implement tax avoidance measures to curb the use of tax shelters, particularly Mauritius where 40% of inward investment is channelled. It also plans to amend laws so it can retroactively tax capital gains from the sale of Indian companies outside India. This amendment was prompted by the Indian Supreme Court’s dismissal of a US$2.2 billion tax claim on UK-based Vodafone stemming from its purchase of Hutchison Whampoa’s Indian telecom business in 2007. Several other cases, involving a total tax bill of US$7 billion, are also under litigation.

India’s challenges have implications for Australia, because the subcontinent is now Australia’s No 4 export market, consuming 6% of its exports — chiefly coal, gold, copper and education -related travel.

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.