US - teeters on the "cliff"
An acrimonious debate over the trajectory of fiscal policy is likely to weigh on the US economy and financial markets in the run up to the end of the year.
The US election has settled one uncertainty – who will be president – but another remains, the ‘fiscal cliff’. Unless the President and Congress can strike an agreement, over US$600 billion of fiscal tightening is set to start hitting the economy from January 2013 (Chart 1).
Fiscal tightening of this magnitude would push the economy back into recession. The Congressional Budget Office estimates that it would subtract 3%pts from growth in 2013. For an economy growing at only 2% pa, this would be quite a shock – hence financial markets and business are worried. Much of the tightening relates to the expiration of Bush-era tax breaks, although a quarter are spending cuts imposed through sequester from the Budget Control Act of 2011 (Chart 2).
Few in Washington really want the country to go over the cliff. The most likely scenario is that a patchwork agreement will be reached just in time. Both Republicans and Democrats are said to be working out how to extend, at least temporarily, most of the expiring personal tax cuts and slow the implementation of some of the spending cuts. Though this would still result in a significant fiscal drag of about 1% of GDP in 2013 based on most estimates, it would also give the President and the new Congress more time to negotiate a broader ‘grand bargain’ to help deal with the US’ medium-term fiscal challenges, such as rising entitlement expenditure
The Bush tax cuts for upper-income earners, amounting to only US$44 billion (or 0.1% of GDP), remain the most likely stumbling block to a deal. While President Obama has indicated willingness to negotiate with Republicans, he has made clear he is not prepared to extend tax cuts for upper incomes. Obama has insisted that the tax cuts only be extended for lower and middle incomes.
In contrast, the Republican majority in the House has vowed that no taxes should be increased, although more recently House Speaker Boehner has suggested that Republicans are open to allowing the closure of some tax loopholes, perhaps opening an avenue for compromise.
Greece - debt forgiveness ahead?
With public debt now expected to reach nearly 200% of GDP by 2014 another large debt restructuring seems inevitable. The risk is that European political challenges delay such a deal until it is too late.
Promises by the European Central Bank to undertake ‘outright monetary transactions’ to cap an increase in Peripheral sovereign bond yields have lowered the risk of a highly destabilising eurozone breakup. But this improvement in sentiment could prove fragile, especially if fears about Greece exiting the eurozone resurface in the wake of rising public resistance to the country’s new austerity package and Greece’s still unsustainable debt trajectory. A Greek exit could have wider implications for eurozone stability if it demonstrated that euro membership could be reversed.
The recent Greek parliamentary approval of a new fiscal package – which slashes public sector pay and pensions – has opened he door to the release of €31.5 billion under Greece’s second bailout program and to a renegotiation of some of its terms. The speculation is that Greece will receive a two-year extension on its fiscal targets as well as lower interest rates on its official loans. However, the Troika of lenders can’t agree on who will fund the extension of Greece’s bailout – €15 billion in new financing by 2014, and perhaps as much as €32.6 billion by 2016. Some Eurozone leaders are threatening to withhold additional funds.
Even if new terms are agreed, Greece’s debt load still looks unsustainable (Chart 1). The recent budget projected that public debt will peak at 192% of GDP in 2014, well above the still-high peak of 164% envisaged under the terms of the second bailout announced only eight months ago. This suggests a sizeable debt writedown is inevitable at some point. Indeed, the IMF will only provide additional funds if Greece’s debt is viewed as being on a ‘sustainable’ path.
The ability of the economy to tolerate further austerity and reduce its debt load on its own is diminishing rapidly. The economy is forecast to contract by 22% between 2008 and 2013 (4% in 2013 alone), unemployment is 25%, and public support for spending cuts and tax hikes is flagging (Chart 2). Youth unemployment is 55%.
Still, resistance within Europe to a sizeable debt writedown is likely to be strong. Much of Greece’s remaining debt is owed to the official sector – the IMF, the European Financial Stability Fund (EFSF), and the ECB. One fear is that a large writedown would threaten the solvency of the EFSF. Many creditor countries are also worried that writing down Greece’s official sector debt would formalise a transfer of resources and reward ‘bad’ behaviour. Support pledged to Greece over 2010-14 already totals €237.5 billion.
Another complication is the delicately balanced political situation. Power is held by a fragile three-party coalition and the popularity of one member of the coalition – PASOK – has fallen to an all-time low. The fiscal measures included in the budget have caused severe friction within the coalition, raising fears about its durability, and therefore about Greece’s ability to deliver on its promises. Given this febrile environment, any sign of political fragmentation could quickly reheat the market’s fears about Greece exiting the eurozone.
China - economy stabilises
October data suggest the slowdown has run its course. This is positive for Australian exporters, who now send 25% of their exports to China.
Over the past year slowing GDP growth has raised concerns that a ‘hard landing’ might eventuate in the world’s second largest economy and Australia’s largest trading partner. Over the year to the September quarter, GDP grew by ‘just’ 7.4%, the slowest rate of growth since the global financial crisis.
However, a raft of data for October suggests growth may be recovering as 2013 approaches.
- Fixed asset investment by state-owned enterprises has accelerated, as monetary policy has loosened (Chart 1). Investment by the central government has also jumped. In particular, investment in China’s railways has re-started after being curtailed following a high speed train crash in mid-2011. Growth in real estate investment remains soft, but rebounding property sales, rising prices and increase in loans for land purchases suggest the market has turned.
- Other industries have also strengthened (Chart 2). Retail sales also grew by 14½% over the year to October, up from 13% in July. Meanwhile, merchandise exports grew by 11½%, with exports to non-EU markets rebounding.
- Consistent with the pick-up, electricity output was 7% higher over the year to October – the fastest rate of growth since March (Chart 3).
The economic pick-up has had a mixed effect on Australian commodity exports. It has failed to support thermal coal exports. Data up to September suggest that higher electricity production reflects increased hydro, not thermal, electricity. But the recovery in infrastructure investment has increased steel prices. This has helped support a rebound in iron ore prices, after they fell sharply over July and August (Chart 4). Base metal prices have also strengthened.
Japan - Trade raises long-term issues
The Japanese economy looks to have entered its fifth recession in 15 years. Part of the slump reflects a deteriorating trade balance. If sustained, this could have implications for Japan’s LNG supply arrangements and the ease with which the government finances.
The economy contracted by nearly 1% in the September quarter, as post-earthquake reconstruction rebound faded and exports weakened (Chart 1). Business surveys suggest that the economy will shrink again in the December quarter. The recovery from the global financial crisis has been patchy and the economy is about the same size as it was at end-2006.
Part of the GDP weakness reflects a rapid deterioration in the trade balance. The trade balance has been in since March 2011. Exports have struggled – due to weak world growth and the strong yen – while imports have continued to rise (Chart 2). An export rebound in the near-term is unlikely – the world economy remains soft and territorial tensions over islands in the East China Sea has created uncertainty for Japanese businesses in China.
If sustained, a trade could also have long-term implications for the LNG market and the Japanese bond market.
- Persistent trade may increase pressure from within Japan to try to source cheaper LNG from outside Asia and the Middle East, perhaps by importing a greater of portion of its LNG from the US where it is not oil-linked. Otherwise gas prices risk putting Japanese exporters – already struggling from the high yen and strong regional competition – at a competitive disadvantage. At present, Japan is buying LNG at US$17/mmbtu according to the World Bank. In contrast, domestic gas prices in the US are around US$3.50/mmbtu (Chart 3). However, there are two caveats. First, most US LNG projects have yet to receive export licences over fears that a sharp rise in gas exports would lead to significantly higher domestic prices. Second, after accounting for transport and liquefaction costs, US LNG would not be significantly cheaper than oil-linked prices if oil prices eased or domestic gas prices in the US rose.
- The current account is set to shift by around 2015 on most estimates, which signals that the government will soon need to rely more on foreign capital to cover its debt needs. Up till now a large surplus of private sector savings has enabled Tokyo to find cheap and plentiful finance, despite the large debt stock and weak economy (Chart 4). The National Pension Fund, one of the largest institutional investors in government bonds, has started drawing down on its assets as Japan’s ageing households draw upon their savings to fund retirement.
Philippines - on the verge of investment grade
The Aquino administration’s efforts to rein in the fiscal, combined with the Philippines’ strong balance of payments, suggest the country will soon reach investment grade status. To climb the investment grade ladder, however, some long-term structural issues may need to be tackled.
In late October, Moody’s upgraded the Philippines to Ba1, aligning its rating with those of S&P and Fitch at just under investment grade. Further fiscal improvements and stable economic growth are likely to see the Philippines reach investment grade sometime in the next two years. The bond market is already there, with yields on Philippine US$ bonds trading below investment grade bonds from Indonesia (Chart 1).
Approaching investment grade shows that the Philippines is making progress, but it does not mean that all the economy’s long-standing weaknesses have been tackled. In particular, the domestic economy is still growing too slowly to provide jobs for the rapidly expanding population. Annual real per capita income growth has averaged below 3% over the past decade. In fact, at US$2200, per capita income is a third less than Indonesia’s and is well below the regional average (Chart 2). Ironically, the inadequate job creation capacity of the economy forces roughly one in 10 Filipinos to work
abroad, yet these ‘OFWs’ create a $20 billion gush of remittances that impresses the ratings agencies.
The government is using its newly found fiscal space to improve the country’s infrastructure. This will help boost the country’s potential output and hence job creation. However, reforms to liberalise the economy, encourage greater competition and increase private investment would also help. On some measures the business climate, such as the World Bank Doing Business Survey, is still one of the worst in the region. Reflecting this, foreign direct investment has averaged just 1.2% of GDP over the past decade. Improvements in these areas would lead to a broader improvement in the Philippine’s performance and open greater avenues for Australian exporters and investors to access this large market of nearly 100 million people.
Roger Donnelly, Chief Economist
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