World Risk Developments September 2012


ECB launches 'Outright Monetary Transactions'

The transactions are an important step, but won’t by themselves fix the eurozone.

On 6 September, the ECB agreed to act as a lender of last resort to eurozone governments that have been priced out of bond markets. The Bank has agreed to buy bonds without limit in the secondary
market – something it calls outright monetary transactions, or OMTs. Markets applauded, with the euro rallying and Spanish and Italian bond yields dropping sharply.

As the Belgian economist Paul de Grauwe has noted, the eurozone crisis has thrown up a paradox. The bond market demands a far higher interest rate of the Spanish government than of the British
government, even though Britain has larger debt. Why?

De Grauwe argues that in the face of a British bond sell-off, the pound depreciates, bottling up proceeds from the bond sales in the British money market, and leading some of the liquidity to be reinvested in bonds. Even if there is no reinvestment, the Bank of England steps in to buy the bonds. If the same fate befalls Spain, the money from the bond sales leaves the country and shrinks the Spanish money supply. Even worse, the Bank of Spain can’t step in to prevent a sovereign liquidity crisis.

In other words, the British government avoids debt default thanks to its flexible exchange rate and lender of last resort. But the Spanish government, without these advantages, is left prone to default.

The OMTs mean that illiquid, but solvent governments within the euro area will now have a lender of last resort. In theory, this means that so-called bond market vigilantes can no longer drive up sovereign bond yields (and potentially force eurozone governments to default) for no good – ‘fundamental’ – reason. On the surface, then, the ECB’s OMT program would seem to be a big step towards resolving the eurozone crisis.

There are, however, complications, both political and economic.

To get access to the facility, governments will need to sign up to an agreement with the ECB/EU/IMF troika that will have strings attached. Governments may hesitate to do this for fear of the stigma. The ECB says it will stop its OMTs if a country fails to meet the conditions of their bail out agreement. This means that the OMTs minimise, but won’t remove altogether, the tail risk that a country defaults on its debt and exits the eurozone. Therefore, there is a chance that bond yields in countries that have been bailed out could still get out of hand and lead to a self-fulfilling bad equilibrium.

In addition, governments will have to be quick to take advantage of the breathing space provided by the OMT by pushing through fiscal and structural reforms that boost competitiveness and growth, and promote rebalancing. This may be difficult if eurozone economies remain weak.

Unrest in South Africa's mining industry

Disputes in the mining industry highlight the country’s broader economic problems.

South Africa’s mining industry has been the focal point of strikes and protests in recent weeks, some of which have turned deadly. The strikes started in platinum mines, but the unrest has spread to other mines, threatening output in an industry that produces more than 8% of GDP. Australian mining and mining service companies have a sizeable stake in South Africa’s minerals sector – the country hosts 134 Australian sponsored mining projects and 44% of Australian mining equipment and technology services companies have operations in the country.

Although the strikes are ostensibly for better pay and conditions, the causes go deeper. Power struggles between unions is one such cause – new unions are competing for members with incumbents. Another is frustration about the country’s failure to live up to its economic potential – poverty is still widespread, jobs in the formal sector are limited, and public services are poor.

The mining industry typifies the economy’s failure to develop. South Africa contains some of the richest mineral deposits in the world, including 80% of the world’s platinum. But since the rally in commodity prices began in 2002, the industry’s share of GDP has barely moved (Chart 1). Mining output has actually decreased, largely because of plummeting gold production (Chart 2).


There are several reasons for this sluggishness. Many of the country’s mines are more than a century old and becoming increasingly difficult and costly to exploit – ore grades have deteriorated and miners need to go deeper underground. In addition, skilled labour is hard to find and costly. Ageing infrastructure isn’t helping either – years of under investment have forced Eskom, the state power utility, to ask mining companies to curtail their power use or face supply interruptions.

Perhaps these factors would be surmountable if the country’s investment and regulatory climate was better. But South Africa ranked only 54 out of 93 jurisdictions on the Fraser Institute’s Policy Potential Index (part of the Institute’s annual survey of mining companies and a measure of the attractiveness of various jurisdictions for mining investors) in 2012, down from 14 out of 45 a decade ago.

High food prices hit Africa and Middle East

High food prices are causing hardship in Africa and the Middle East – and hardship could lead to political instability.

The FAO’s food price index has more than doubled since the early 2000s, a sharp turnaround from the decline observed during the 1990s. All components of the index have risen sharply (Chart 1). Supply and demand are both responsible for the rise in prices. Population growth and changing food consumption patterns have boosted demand, while periodic supply shocks have affected the production of particular agricultural commodities. Recent rises in the price of corn and soyabean, for example, are traceable to a serious drought and summer heatwave in the US that destroyed 45% of the corn and 35% of the soybean crop. Bad weather, incidentally, has contributed to three food price spikes in the past five years – 2008, 2010–11 and 2012.

In poor net food importing countries, price rises can impose real hardship, which can in turn lead to political unrest. Mozambique, for example, experienced food riots in 2008, and high food prices were at least a contributing factor to uprisings during the Arab Spring in 2010. The summary in Chart 2 suggests that low income African and Middle Eastern countries are most prone to instability in the face of high food prices. Australia, which is a competitive agricultural exporter, is one of the least vulnerable countries to food price spikes.


Turkey's Eurozone drag

The eurozone crisis has caused a slowdown in Turkey’s economy and highlighted latent weaknesses.

Turkey’s economy has slowed to around 3% in the year to June 2012 from 8-11% in 2010 and 2011 (Chart 1).

In one sense, the slowdown is welcome. The expansion was built on shaky foundations, notably surging domestic demand, including a buoyant construction sector. It was associated with a credit boom and a sharp increase in the current account deficit (Chart 2) and inflation. The economy now appears much more balanced – domestic demand has cooled and the current account deficit has narrowed (Chart 2).

But Turkey’s exports to core European markets have slowed dramatically, particularly automotive products, textiles and clothing. An extended period of weakness in Europe will further crunch these exports, and therefore GDP growth, as is already happening in other countries that export to Europe, including China, Japan and South Korea.

So far, investors don’t appear too worried, with many expecting a soft landing – the sovereign risk premium over US Treasuries continues to fall (Chart 2) and recent comments from Fitch hint that an investment grade rating might be close. Still, the country remains vulnerable to shifts in sentiment because of its high net external debt and large gross external financing needs – Standard & Poor’s estimates that Turkey’s external financing needs will reach 142% of current account receipts plus usable reserves, the highest of all countries rated by the agency.


Banking crisis in Vietnam

Vietnamese banks are struggling under a large stock of bad debt. The government will need to help the sector consolidate, write off bad debts, and boost capital levels if the economy is to regain its vigour.

The banking system is now in crisis after years of rapid credit expansion and lax risk management. Bad debts have surged, as asset prices have weakened, credit conditions have tightened, and growth has slowed. Credit has tripled from 35% of GDP in 2002 to 120% in 2011, extremely high for an emerging market (Chart 1).

The central bank has estimated that non-performing loans (NPLs) were 9% of total loans in the March quarter – triple the 3% they estimated for end-2011. In addition, banks were said to be systematically under-reporting bad loans. Private analysts put the NPL ratio even higher – Fitch at 13%. Loan loss provisioning is also very low at 60%.

This month, a government report estimated that the sector needs US$9 billion of new capital, equivalent to 12% of GDP, to cover loan losses. While large, such a figure does not seem insurmountable.

  • The government could fund it by borrowing – it has relatively low external debt (around 25% of GDP).
  • It could also encourage more private capital into the sector.
  • Analysts consider Vietnam will only request an IMF loan if the country’s difficulties cause wobbles in the balance of payments.

Still, the authorities will have to move quickly if Vietnam is to avoid a vicious cycle where banks, saddled with bad debts, continue to curtail lending, which leads to weak GDP growth and falling asset prices, and hence further rises in bad debts. The brief instability in the funding markets and stock market plunge after the arrest of banking tycoon Nguyen Duc Kien – the founder of Asia Commercial Bank, Vietnam’s largest private bank – highlights the anxiety surrounding the sector. The economy grew by 4.4% over the year to June, a noticeable change of pace from the last couple of years (Chart 2).


Korea's credit rating goes up as its economy slows

Moody’s has upgraded Korea just as a slowdown increases concerns about high household debt.

In August, Moody’s upgraded Korea’s sovereign credit rating to Aa3 from A1. Moody’s pointed to the country’s strong fiscal position and the declining reliance of banks on offshore funding (Chart 1).

The upgrade has come just as a sharp and broad economic slowdown gets underway. Industrial production and exports – which account for more than half GDP – have fallen by 5% over the past year (Chart 2). Meanwhile, private consumption grew by just 1½% over the year to June, and investment is declining (Chart 3).

The slowdown has also increased concerns about household indebtedness. Korea’s household debt-to-income ratio is higher than in most OECD countries at 135%. In addition, about a third of mortgages are short-term “bullet” loans that need to be rolled over within three years – a difficult prospect if house prices fall. House prices have already weakened in Seoul, although not countrywide (Chart 4, LHS). There has also been a strong rise in lending by the non-bank sector where lending standards are not as strict and loans are often to low-income households.

Mitigating the risk of a debt crisis is a low aggregate loan-to-value ratio – only 50%. The overall financial position of households remains relatively strong, with debt to financial assets just under 50% and debt-to-liquid assets just over 100%. Moreover, despite the slowing growth, the labour market has remained strong, with unemployment just 3.1% in July and employment expanding quickly (Chart 4, RHS). Finally, the authorities have fiscal space – as the rating upgrade by Moody’s highlights – to support activity if the economy worsens and a willingness to intervene (on 10 September the Government announced a further KRW4.6 trillion in stimulus measures to supplement its KRW8.5 trillion package announced in June).

The slowdown has implications for Australia, because Korea is Australia’s No 3 export market, buying 8% of exports – chiefly iron ore, coal, fuels, and agricultural products.


China cushions Australian tourism downturn

Inbound tourism has continued to rise despite the high A$, thanks mainly to Chinese tourists. The trend is likely to continue as China’s middle class expands.

The difficulties in the tourism industry reflect a surge in Australians travelling overseas for holidays rather than a downturn in inbound travellers. In recent years, inbound tourism numbers have tracked higher despite the high A$, rising by 5% over the year to June 2012 (Chart 1).

The mix of tourist arrivals is changing (Chart 2). Tourists from China and other Asian countries are arriving in greater numbers. Since January 2009 the number of Chinese arrivals has risen by more than 60%. The number of Chinese visitors to Australia is now equal to the number from the UK and nearly double the number from Japan.

Rising Chinese tourist numbers are a worldwide trend. In 2011, Chinese tourists spent US$73 billion on international tourism, behind only the US and Germany (Chart 3). The Australian tourism industry appears well placed to capture its fair share of these tourists. Despite the high A$, the growth in Chinese visitors to Australia have broadly kept pace with the rise in Chinese visitors to other countries in the region (Chart 4).


Roger Donnelly, Chief Economist

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