World Risk Developments April 2013


World economy – Proving hard to read

Are advanced economies at risk of stalling, or are they picking up speed? Are the risks facing the world economy increasing or diminishing? Prominent forecasters hold differing opinions.

World economic growth is ‘picking up steam’ and should accelerate both this year and next. Better yet, the advanced economies have ‘successfully defused two of the biggest threats to the global recovery – a breakup of the euro area and a sharp fiscal contraction in the United States caused by a plunge off the ‘fiscal cliff’.’ That is the view of the IMF in its just-released World Economic Outlook.

Or alternatively ... the recovery ‘remains stuck below takeoff speed, unable to achieve liftoff and facing the risk of stalling’, according to the latest Brookings-Financial Times tracking index of recovery (TIGER).

Can these views be reconciled, or are they at odds? Actually, both the IMF and TIGER share a lot of common ground. Both see comparative bright spots in America (strengthening), Japan (strengthening) and China (stabilising). (Though neither has been able to register the latest disappointing growth number from China – next story.) Both also worry about the euro area (prolonged stagnation or escalating crisis). Yet TIGER sees a greater risk of ‘policy and political uncertainty’ ‘preventing the world economy from attaining liftoff, and raising the risk of a crash’, while the IMF chooses to stress diminishing risk in the euro area and US. Finally, the Fund admits that medium term risks persist, relating to ‘adjustment fatigue, insufficient institutional reform, and prolonged stagnation in the euro area [and] high fiscal and debt in the United States and Japan’.

China – Growing pains

The economy’s credit-fuelled, investment-led growth is reaching limits. Rebalancing is necessary.

Anxiety about the Chinese economy is growing, and coming from two directions – rising bad debt in the financial system and slowing growth.

Credit rating agency Fitch downgraded on April 9 China's long-term local currency debt from AA- to A+, citing high debt levels that might ultimately require the central government to bail out banks and local governments. Then March quarter data released last week showed year-on-year GDP growth slowing to 7.7%, from 7.9% the previous quarter.

The downgrade is the first by a major rating agency of China since 1999. Fitch said that total credit may have reached 198% of GDP last year, up from 125% in 2008. This credit boom has been driven by two things – first, the big stimulus package introduced in 2009 to combat the global financial crisis; then the rise of shadow banking, which has continued to expand rapidly despite efforts to control it. Both have left a legacy of bad loans to local government investment projects

Though the March quarter growth figure was above the 7½% official target, it challenged the consensus that growth had stabilised after a slowdown last year, and would accelerate modestly to around 8% in the first half of 2013.

The bigger uncertainty about the growth outlook concerns rebalancing, not financial system risk. If worse comes to worst, the central government should be able to afford a bailout of local governments or (once again) a recapitalisation of banks. But if growth slows further because of falling investment and sluggish consumption, it is unclear what Beijing will do. Previous incoming administrations have often launched large investment programs to shore up their economic credentials. Yet the fifth-generation leadership of President Xi Jinping and Premier Li Keqiang has expressed strong support for rebalancing and seems prepared to accept lower growth as long as this does not cause significant unrest. So another big stimulus in the event of a downturn isn't assured.

What are the implications of these growing pains for Australian business? With China now Australia's largest export market, accounting for 25% of goods and services exports, interest in the ups and downs of the Chinese economy is understandably high.

There are two issues to consider. First, the short-term downside risk of a slowdown brought on by financial difficulties. This would have obvious knock-on effects to Australia. Second, the medium-term outlook. Here there is reason to believe that China is settling into a lower growth range than before, perhaps 7-8%.

How would growth in that range translate into Chinese demand for Australian exports? Here opinion divides, depending on the view one takes about international commodity prices and China's 'commodity intensity of GDP'. On a dim view, growth of resource export volumes to China becomes sluggish, or even falls, and the prices received for those exports also fall. On a perhaps more plausible view, China's commodity intensity of GDP remains high for a while yet as it completes its industrialisation and urbanisation. This in turn keeps resource export volumes growing, though prices may come off as new worldwide supply capacity starts production. Better still, a rapidly growing Chinese middle class generates new demands for services such as tourism and education which Australian suppliers capture a share of.

Cyprus – FAQs

We answer questions on the recent bank rescue package.

First of all, what does the package entail?

The Eurogroup of finance ministers that manages the single currency reached agreement with Nicosia on the package on March 25. The details are here.

The authorities had three options to recapitalise the two main Cypriot banks, Bank of Cyprus (BOC) and Cyprus Popular Bank (Laiki) – 1/ a bail-out from the rest of the eurozone; 2/ a bail-in of various bank shareholders, creditors and depositors; or 3/ a combination of bail-out and bail-in. At Germany's insistence, a straight bail-out was rejected – Cypriots had to share the burden of absorbing the losses with taxpayers in the wider eurozone and Nicosia mustn't be saddled with unmanageable debt.

The first package to be devised involved a bail-out plus a sweeping bail-in of bank shareholders, unsecured creditors and depositors. In particular, the plan sought to impose a levy on all depositors, small and large alike. But in response to an uproar that this victimised ‘widows and orphans’, the authorities backed down. They then moved to the current plan. This is also a bail-out/bail-in combination, but leaves whole insured savers with deposits below €100,000. Under this plan

  • Laiki will be split into good and bad banks, with its good assets folded into BOC
  • all deposits below €100,000 will be ‘safeguarded’
  • junior and senior unsecured bondholders in Laiki will be wiped out
  • savers in Laiki with deposits above €100,000 will obtain whatever value the bad bank’s assets turn out to have
  • savers at BOC with deposits above €100,000 will have their accounts frozen and suffer a haircut of unknown size, but probably large, reportedly 40%
  • capital controls will be imposed to prevent deposit and capital flight
  • the EU and IMF will release a €10 billion facility – the bail-out element
  • Nicosia will contribute €7 billion.

This package is the fifth one to be extended to a eurozone member, after Greece, Ireland, Portugal and Spain – but the first to bail in depositors. Note, however, that it is not the first to bail in unsecured creditors – this has already happened in Ireland and Spain, and in the wind-up of SNS Reaal in Holland.

In the latest instalment of the story, it was revealed on April 12 that the €17 billion bailout estimate was inadequate; €23½ billion would really be needed. The EU/IMF contribution will remain €10 billion, but Nicosia is now expected to provide €13½ billion – nearly twice as much as previously. To raise this sum, it will reportedly not just wind up Laiki, but write off most of the uninsured deposits and secured debt of BOC, raise capital gains tax and corporate tax, and sell €400 million of gold reserves.

Will the package become a blueprint for other eurozone banking systems in trouble?

‘Yes’ and ‘No’ seems to be the answer of Eurogroup president Jeroen Dijsselbloem.

‘The response will no longer automatically be we’ll come and take away your problems. We’re going to push them back ... You deal with them.’ That was his first answer

But then he 'clarified'. ‘Cyprus is a specific case with exceptional challenges … adjustment programs are tailor-made … no models or templates are used.’

He is probably right in both answers – and isn't contradicting himself.

The Eurogroup WILL push back in any future eurozone banking crisis – to discourage moral hazard, to limit costs to eurozone taxpayers and to crisis-hit governments alike, and above all, because 'BAILOUTS FOR BANKERS' doesn't play well among eurozone voters.

Shareholders, then junior unsecured creditors, then more and more senior creditors, will be written down or wiped out to make insolvent banks solvent again, and to restore capital buffers. If need be, even uninsured/unguaranteed deposits will be shorn. Only secured creditors and insured/guaranteed depositors will be spared. Or more accurately, efforts will be made to spare them.

But note that eurozone deposit insurance/guarantee schemes aren’t funded; they are only promises. If a government can't honour those promises, the eurozone will have to come in with a bailout package to back them up. And if it doesn't, uninsured/unguaranteed depositors – the widows and orphans – will have to be written down.

How is Cyprus a special case that might mean depositors in banking crises to come will be spared? In three ways. First, the Cypriot banking system has a bloated balance sheet – equivalent to 700% of GDP. Second, it has an outsized share of deposits in its liabilities – around 85%, according to a Citibank estimate. Third, it has from all accounts very poor asset quality – stemming from ill-judged decisions to buy Greek assets just as everyone else was selling.

So the solvency hole in the Cypriot banking system balance sheet is especially deep, and this hole is a large fraction of GDP. Worse still, there are not a lot of non-deposit liabilities that can be written off to fill the hole. Therefore, depositors were placed in harm’s way, and it took an EU/IMF bail-out to shield the small insured ones, though not the large uninsured ones.

Conversely, in a country with a smaller and less insolvent banking system, less dependent on deposits, and with a financially stronger government able to pay deposit insurance claims, depositors will be less in jeopardy, even large uninsured ones.

Even in countries with financially strong governments able to bail out troubled banks, the willingness to do so after Cyprus has probably declined. The likelihood of unsecured creditors being bailed out certainly seems less. Only depositors have some assurance of being rescued. This seems to be another area where the Cyprus blueprint will leave its imprint.

Will the Cyprus rescue cause contagion elsewhere in the eurozone?

According to some observers, the close shave given to small Cypriot depositors, and severe haircut to large ones, will make depositors in other shaky banking systems nervous. They will withdraw deposits en masse and that will bring on other banking crises.

So far that hasn't happened, presumably because depositors see Cyprus as a special case for the reasons given in the previous FAQ.

Yet there are other banking systems with resemblances to Cyprus. Luxembourg’s banks have assets equivalent to 21 times GDP and a large share of deposits in liabilities as well, especially if one counts external liabilities. Malta has banking assets equivalent to more than 8 times GDP, and Ireland assets approaching 7 times GDP. For other eurozone countries, the multiple is in the 2-4 range.

Spain is in that more normal range, yet has also been mentioned as a country in need of additional funding to recapitalise its banks.

All of these banking systems do look more vulnerable in the wake of the Cyprus rescue.

This point hasn't gone unnoticed in Luxembourg and Malta. Luxembourg's finance minister said recently that his country had about 140 well-structured and properly monitored international banks and a AAA rating from all three credit rating agencies. Better still, his banks had a diversified customer base, sophisticated range of services, efficient supervision and implementation of international standards. In Malta, the central bank governor has acknowledged that banking assets are 8 times GDP, but noted that international banks there conduct hardly any local business, and the ratio for domestic banks' assets is within normal limits at just below 300% of GDP.

What about capital controls? Will these now become more prevalent?

The capital controls imposed by Nicosia are a first for a eurozone government. Moreover, they are severe and comprehensive. They restrict, among other things, cash withdrawals, cashing of cheques, automatic cash transfers for large commercial transactions, the taking of cash out of the country, and spending by Cypriots abroad. In other words, both the external and internal convertibility of ‘onshore’ euros is being curtailed. 

The authorities insist that the controls are temporary, and they have in fact lifted or moderated some, after the banks reopened following a 12-day holiday and it became clear that deposit outflows weren't severe.

Other governments will presumably impose such controls only in similar extreme circumstances, and as the previous FAQ has explained, such circumstances are unlikely to crop up frequently.

Still, they could occur. So capital controls elsewhere can’t be ruled out.

Has the Cyprus rescue made the eurozone more prone to fragmentation?

Many observers have noted that by imposing capital controls, Nicosia has already adopted a de facto separate currency. ‘The authorities have in effect launched a new parallel currency convertible to the standard euro at an exchange rate of one to one, but only up to €5,000, the monthly transfer limit’, says Wolfgang Münchau in the Financial Times.

But will Cyprus now go further, and adopt a de jure separate currency? And will that have a demonstration effect for other countries on the euro-periphery?

Ever since the onset of the eurozone crisis, there was a risk that troubled countries on the periphery would grow weary of internal devaluation – the slow, grinding deflation of wages and prices relative to trading partners that eventually induces an export-led recovery. They might instead choose to re-adopt their own currencies to induce a more rapid external devaluation.

That temptation must surely now exist in Cyprus. And if it yields, and the subsequent devaluation spawns a quick recovery, other peripherals could well try to follow.

How does all of this matter for Australia?

On one view, it matters little, because the eurozone now buys less than 5% of Australian exports. But this is too narrow a perspective. Instability around the euro-periphery can undermine eurozone growth, and then growth in Australia's Asian trading partners, and therefore world growth, and international commodity demand and prices. Meanwhile, it can cause turmoil in world financial markets, though with less clear implications. During the global financial crisis, an increase in risk aversion made life difficult for Australian banks seeking offshore wholesale funds. Nevertheless, since then, Australia has come to be seen as a safe haven for risk averse investors. This means that an escalation of the eurozone crisis wouldn't necessarily cause Australia a funding problem, but it could leave the country in the uncomfortable position of having a strong Australian dollar while export markets are softening.

Malaysia – Electoral uncertainty

The ruling Barisan Nasional (BN) party is poised to lose seats, maybe even government, at next month's election and that is creating economic uncertainity.

Malaysia, Australia’s 12th largest export market and a sizeable investment partner as well, goes to a general (national and regional) election on May 5. The election is shaping up to be the closest in the country's democratic history. The incumbent Barisan Nasional party (BN), which has ruled Malaysia since its independence 56 years ago, will face an opposition coalition party, Pakatan Rakyat (PR), gaining popularity, particularly among younger and middle class voters.

Because of its dominance, the BN seems unlikely to lose power. It has been courting the electorate with cash handouts and pay rises for civil servants. Nevertheless, the PR may be able to eat into the BN’s parliamentary majority and prevent it from reclaiming the two-thirds majority it lost in 2008, but needs to amend the constitution. The BN’s poor showing in 2008 led the party to replace then prime minister Abdullah Badawi with Najib Razak.

There are three broad electoral scenarios, each with different economic and policy implications.

  1. BN wins comfortably with a sizeable but smaller majority than at the last election in 2008. While such a result would be unlikely to prompt big changes in policy direction, it could weaken the BN’s ability to govern decisively.
  2. BN wins but with a slim majority. This could weaken the BN’s political and economic influence.
  3. Opposition wins. This would create uncertainty about the country’s policy and economic direction. The PR, for example, is promising costly cuts to fuel prices.

Whichever way the election goes, the political arena looks set to become more contestable, and that could delay moves to tackle long-running fiscal problems. Except for a couple of years in the mid-1990s, Malaysia has run fiscal for a long time (Chart 1). It has also done little to control public debt, which officially sits at the 55% of GDP limit the government has set itself.


Philippines – Investment grade at last

The Philippines has won investment grade status from Fitch, but conditions for direct investors lag behind those for portfolio investors.

Ratings agency Fitch recently became the first major agency to grant the Philippines investment grade status. The agency has noted big improvements in macro-fundamentals over the past decade. These include: a substantial fall in public and external debt (Chart 2); a five-fold increase in foreign exchange reserves since 2004; and a persistent current account surplus underpinned by remittance inflows, which has diminished vulnerability to financial crisis.

An upgrade from one or both of the other two main agencies seems only a matter of time.

Good as this story is, it contrasts with the business and investment climate, which still poses difficulties for foreign direct investors and their financiers. As Chart 3 shows, the Philippines lags behind other countries in this area.


One area of interest for Australian companies is the mining industry. As we noted last month, this is a particularly vexed area, with the national government battling provincial governors for policy control, while facing criticism from local religious leaders, green groups and indigenous tribes.

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.