World Risk Developments July 2013


China – Credit crunch part of government's broader rebalancing plan

Last month's credit crunch should be seen as part of Beijing’s effort to restrain runaway credit growth and investment and encourage consumption spending.

The late-June jump in China's interbank lending rate (Chart 1), and the refusal of the People’s Bank of China to intervene, took markets by surprise. From targeting inflation at the end of 2011 to promoting growth in 2012, the central bank now appears to have switched again, reportedly concerned about the build-up of bad loans in the shadow banking system. Its action follows the circulation of several regulations in April directing banks to restrict lending to local government financing platforms. Taken together, these changes seem to herald a shift from double-digit loan growth to single-digit growth.


Though the seeming tolerance of the authorities for slower economic growth, supported by tighter and more discriminating lending, is worrying many Australian businesses, there are two further angles to consider. First, slower growth now is likely to stem asset price inflation and bad debt accumulation, and thereby reduce the risk of a ‘hard landing’ brought on by a subsequent bubble burst and credit crunch. Second, the authorities are taking initiatives to encourage consumption as they seek to restrain credit-driven investment. So the credit crunch shouldn’t just be seen as a short term growth drag, but as a measure aimed at rebalancing the economy to sustain longer term growth.

Portugal – Political crisis calls into question euro area debt strategy

A political crisis in Portugal is threatening the calm that had fallen over the euro area after ECB President Mario Draghi vowed a year ago to ‘do whatever it takes’ to save the euro.

Yields on Portugal's 10-year bonds spiked above 7% (Chart 2) and the sharemarket dropped more than 6% on July 3 after both the foreign and finance ministers resigned. Investors feared that the resignations would break the coalition government and upset a €78bn bailout program supposed to restore Lisbon’s access to world capital markets by June 2014. They also worried that a new bailout program may have to be negotiated in which bondholders would be ‘bailed in’ and given ‘haircuts’ as a way to grant Lisbon debt relief.


The current bailout program requires Lisbon to deliver fiscal austerity and structural reform in return for money to meet its financing needs. Over time, the economy is supposed to revive, enabling the government to outgrow its debts without any need for forgiveness, and eventually make a return to market financing. Yet that is not how things have turned out. The economy has remained stuck in recession with public debt ratios continuing to rise and market access not in view.

More broadly, the program’s wobbles underline the difficulty of restoring fiscal solvency around the euro area periphery without debt relief – especially where a currency devaluation option is not available – and suggest that Greece and Cyprus won't be the only peripheral countries to gain debt relief eventually.

Egypt – Interim government must heal political divisions to stabilise economy

Technocratic reforms are needed to stabilise the crisis-ridden economy, but unless the new government heals the country's deep political divisions, economic progress will be slow and fitful.

Markets surged immediately after Mohammed Morsi’s ouster on July 3 (Chart 3). The rally appears to have been based on three hopes – that law and order would be restored, that the government would manage the economy better, and that relations with creditors would improve. As the violence continued, however, the enthusiasm began to flag, and markets retraced.


Though the prospects of a return to security look uncertain, the grounds for hope on the other two fronts are somewhat stronger. The new prime minister, Hazem el Beblawi, is an experienced economist and former finance minister who has called for the reduction of wasteful and poorly-targeted food and fuel subsidies (amounting to 40% of government revenue or 8½% of GDP) and other market-oriented reforms. His determination to tackle subsidies could help him clinch a US$4.8 billion IMF standby loan, something that eluded the Morsi government. Already Gulf Arab governments, which were largely opposed to the Muslim Brotherhood movement, have moved to back him with US$12 billion in aid pledges – US$5 billion from Saudi Arabia, US$4 billion from Kuwait, and US$3 billion from the UAE. The money will come in three forms – grants, deposits at the central bank, and fuel shipments.

The economy needs financial support and reform badly, because it had already sunk into crisis before the protests started in May. The uprising in February 2011 that deposed Hosni Mubarak depressed the real economy, restricted foreign (including trade) credit availability, triggered capital flight, eroded tax revenues and induced big public spending increases, including an 80% increase in the public sector wage bill. Large dExport Finance Australiaits opened up in the budget and current account of the balance of payments, which the country only managed to finance with the help of an almost two-thirds drawdown of international reserves, the receipt of US$5 billion in aid from Qatar and Libya, a 16% depreciation of the pound, the accumulation of US$6-8 billion in payment arrears to international oil companies, and fuel rationing and power outages.

But technocratic tinkering won't be enough to overcome these problems. Unless el Beblawi can unite the secular and Islamist factions of society, he will fail to create the consensus needed to push through such measures as subsidy reform.

One obstacle he will face will be the resentment of the Muslim Brotherhood, who are likely to boycott the interim government and committee to draft a new constitution. They will probably also call their supporters, who number about one third of the electorate, to boycott planned presidential and parliamentary elections, and declare the result void.

They may even mount street protests against the new government, much as the Tamarod (revolt) movement protested against Morsi. This would in turn force the army to remain on the streets to guarantee security.

Such a course of events may guarantee political stability for a period, and bring a modicum of economic stability. But it would be a poor sort of equilibrium, in which much potential growth and development ran to waste because foreign and domestic investors were holding back and tourists looking elsewhere, and the government was prone to budgetary crises.

Turkey: Protests increase country risk

The recent street protests in Istanbul and Ankara have shown up economic vulnerabilities. The risk of external debt rollover difficulties, capital flight and an abrupt lira depreciation has increased considerably.

Until recently, Turkey was struggling to cope with too much capital inflow. Two factors were driving this inflow – the ‘reach for yield’ in world financial markets and the promotion of Turkey to investment grade by two ratings agencies (Fitch last November and Moody's in early May). To ease the resultant appreciation pressures, the central bank was actually cutting interest rates.

But then in May, some hawkish Federal Reserve officials began to muse about QE taper in 2014, and investors began to pull money out of emerging markets, including Turkey. And then the protesters began descending upon Taksim Square on May 31.

Market sentiment changed abruptly. Bond investors reportedly withdrew US$2 billion between mid-May and mid-June, and portfolio equity investors US$1.5 billion. Foreign exchange reserves fell around US$6 billion between late April and early June. The lira has depreciated 4% since 31 May. And the Turkish country risk premium, or ‘EMBI spread’, has risen 104 bp to 276 bp over the same period.

The ebbing of the liquidity tide has shown just how scantily clad the Turkish economy is. In particular, there is a large and widening current account dExport Finance Australiait, financed by flighty short term debt inflows, and a gigantic overall external financing need.

Take the current account dExport Finance Australiait and its financing first. According to the IIF, the 2012 dExport Finance Australiait amounted to 6% of GDP, 92% of which was financed with inflows of portfolio capital and short term borrowing. Because short term foreign borrowing has been the main financing source of the current account dExport Finance Australiait since 2009, short term external debt rose to 12% of GDP in 2012 from 8% in 2009. Meanwhile, FDI inflows declined to as little as 1.6% of GDP from an already low 2.2% in 2011. The composition of external financing deteriorated further in early 2013, with FDI inflows declining to 1% of GDP during January-April from 2.4% a year before.

The gross external financing need could add up to US$220 billion in 2012, or 24% of GDP, because of three things – a current account dExport Finance Australiait of, perhaps, 6.6% of GDP, principal repayments on medium/long term foreign debt equivalent to 5.3% of GDP, and a short term debt rollover need of the remainder. Even assuming that FDI inflows amount to 1.5% of GDP and all medium/long term repayments plus half the short-term debt (largely trade credits) are rolled over, the vulnerable part of the financing need would remain substantial at around 11% of GDP. The financing need compares with foreign exchange reserves of roughly 13% of GDP, or $108 billion, in early June.

For the time being, the protests have subsided. But if they flared up again, the economy could be prone to debt rollover difficulties, reinforced by capital flight.

A large lira depreciation could result. Either that, or the central bank would have to impose widespread exchange and capital controls. Either way, there would be a big drag on the economy’s growth and big debt repayment difficulties.

The private sector appears to be the most vulnerable to external debt rollover risk, because its short term debt has more than doubled to US$101 billion since 2009, with the bulk owed by banks.

In a large depreciation, Turkish companies would be vulnerable, because they have a very large unhedged FX open position of US$146 billion.

Banks do not have such large positions. But they would still be affected in a roundabout manner, through their loans to companies, many of which would turn bad.

Brazil – Protests expose flaws in country’s growth model

The street protests have subsided, but the grievances behind them are far from resolved.

Triggered by a bus fare hike in Sao Paulo and fed by anger over lavish spending on football stadiums for the 2014 World Cup, they were the largest protests in two decades. Their root causes are harder to see, but growing discontent with poor public services, inequality and poverty is the chief suspect.

That discontent in turn seems to have arisen from three sources.

First, an expanding middle class. A decade-long boom enlarged this group considerably, and it began to demand better public services and infrastructure and cleaner politics. Second, stubborn inequality. Despite the growing middle class and increases in social and education spending, Brazil remains one of the most unequal economies in Latin America. Third, faltering growth. The economy is now running out of steam (Chart 4) – held back by a combination of cautious consumers, sluggish external demand and weak private investment. The latter reflects the country’s high‑cost industry structure, infrastructure bottlenecks and subdued business confidence. At the same time, inflation has remained stubbornly high and the central bank has raised interest rates to rein it in, further damping the economy’s momentum.


President Dilma Rousseff's approval rating plunged in the wake of the protests. But there is as yet no suggestion that she is a spent force – polls suggest that if an election were held today, she would win, but face a run-off against Marina Silva, a former Green Party candidate who is trying to form an alternative political party.

Rousseff’s response has been a five-point plan focused on political reform and investment in public services. It hit an early snag when she proposed a constituent assembly to overhaul the country's political system, but then withdrew the plan a day later after it met widespread opposition, including from her own party members.

Despite making the right noises, the government will probably struggle to meet the public’s expectations, particularly since Brazil’s federal structure assigns responsibility for most public services to state governors rather than Brasilia. Besides, the deteriorating economy will constrain the government’s ‘fiscal space’, already under strain from a low tax take and bloated spending demands – most social spending is constitutionally mandated, leaving little scope to focus on other priorities, such as numerous infrastructure shortcomings.

Brazil is typically seen as a competitor for Australian companies exporting iron ore to China, and in international food markets. But there is dawning recognition of complementarities between the two countries and of opportunities to collaborate in many industries and markets. In addition, Australian exports to Brazil are considerable – just under $1 billion in 2012. Brazil is also a sizeable investment destination for Australian firms – the stock of investment there totalled $14.3 billion in 2012.

Mongolia – Re-elected president unlikely to go easy on mining industry

The risk of political interference in the mining sector will remain as long as the government is divided over foreign ownership. But we don’t believe it will forcibly increase the state’s share of existing and prospective mining projects in the current presidential term.

Incumbent President Tsakhiagiin Elbegdorj took 50.22% of the vote in the June 26 election, narrowly avoiding a second-round run-off election.

The result means that the Democratic Party now controls all four top political positions in the country until 2016 – president, prime minister, speaker and mayor of Ulaanbaatar. This dominance provides Elbegdorj with the chance to renew his previous focus on institution-building – strengthening the judiciary, improving government transparency, combating corruption and decentralising authority.

While this sounds encouraging, it has mixed implications for mining projects, many of which are being developed by Australian miners and contractors.

In particular, Elbegdorj has supported proposals, included in the draft Minerals Law, to give local governments more say in approving mining developments either through consent on land acquisition or local co-operation agreements with developers. Similar devolution initiatives in other emerging markets have led to projects being either rejected, or subjected to stiffer conditions.

Elbegdorj has also previously backed proposals to increase the representation of Mongolian nationals on the boards of major mining companies, including Oyu Tolgoi, and establish laboratories to independently verify the metal content of ore exports.

Nevertheless, he has stopped short of supporting initiatives to increase the state’s share of existing and new mining projects by including them on a list of ‘deposits with strategic importance’. This could put him at odds with some of his colleagues in parliament, several of whom have urged increasing the government share by expanding the list of such deposits.

Instead, he will probably focus on policies to increase benefits from existing mining operations by requiring more domestic procurement and job creation and greater financial disclosure.=

Pakistan – Scepticism greets IMF loan talks

Pakistan's economic difficulties have forced Prime Minister Nawaz Sharif's recently elected government to attempt a series of stabilisation and reform initiatives to win IMF bailout funding. But it will have difficulty carrying out the initiatives against the opposition of vested interests.

Islamabad has sought US$2 billion of IMF support on top of a US$5.3 billion loan agreed on July 4, the finance minister said on July 8. In return for the money, the Federal Board of Revenue will reportedly seek to extend the tax net to wealthy Pakistanis currently outside it, press loss-making public enterprises to improve efficiency, ask independent power producers to switch from oil to coal to reduce import costs, and charge bulk power consumers higher tariffs.

The last two measures are designed to ease power shortages and an associated problem of so-called circular debt. The power shortages can last up to 20 hours a day and are estimated to cost 2% points of GDP growth each year.

Considerable scepticism has greeted the announcement because of the failure of a string of previous agreements in 1993, 1995, 1997, 1998, 2000, 2001 and 2008. To the government’s credit, it is seeking to get many of its measures underway before the Fund’s executive board meets to consider the loan in September. But critics have noted little has happened so far on tax enforcement.

Iran – Tighter sanctions put pressure on new president

America and the EU are tightening sanctions on Iran as a new moderate president takes power. Their aim is to draw him to the nuclear negotiating table, but the strategy carries risks.

A new round of US sanctions against Iran came into effect on July 1, just a fortnight after the moderate Hassan Rohani was elected president. The EU has also recently ratcheted up its sanctions, including by banning metal exports.

The new curbs add to an already complex and tight web of sanctions imposed by the UN, the US and EU that restrict trade with Iran and its financing. The sanctions include bans on arms exports and exports linked to uranium enrichment, and restrictions on Iranian oil and gas exports.

They have been a severe handicap on the Iranian economy, frightening off international companies and knocking oil exports and the value of the rial. Shell, Total, Statoil, Italy's ENI, Japan's INPEX and Korea's Kia, among others, have all announced their intention to pull out of Iran or cease trade. Oil exports – which make up 80% of hard currency earnings – have been particularly hard-hit due to reduced purchases by Asian buyers. They averaged 1.1 million barrels a day (b/d) in March, compared to an average 2.2 million b/d in 2011. In the process, oil earnings in 2012 are estimated to have fallen to US$50 billion – nearly half the 2011 figure of US$95 billion. And as oil revenues and foreign currency reserves have fallen, the rial has lost about two-thirds of its value in the past year. The IMF is forecasting a contraction in the economy for the second year in a row.

The recent sanctions seem aimed at persuading the new regime in Tehran to reach a nuclear deal with the rest of the world, something that proved impossible while the previous hardline president, Mahmoud Ahmadinejad, was in power. If talks resume, Tehran would negotiate with the permanent five UN Security Council members plus Germany, or ‘P5+1’ as they are called, to secure a long-term agreement under which sanctions would be lifted in return for Iran meeting international obligations under relevant Security Council resolutions.

The new president certainly seems more willing than his predecessor to talk. He has described his election as a victory for moderation over extremism and has said he would seek the rollback of sanctions. He was himself Iran’s chief nuclear negotiator over 2003-05, and during that time agreed to a temporary cessation of uranium enrichment.

Still, a more cooperative approach can't be guaranteed. For one thing, nuclear policy is set by the more hardline Supreme Leader Ali Khamenei, who remains the most powerful figure in Iran's multi-polar political system. And the recent tightening of sanctions may make the government less inclined to compromise rather than more.

Australia observes UN sanctions aimed at curbing Iran’s ‘proliferation-sensitive’ nuclear and missile programs. These prohibit a range of activities, including the supply of certain dual use goods and services to Iran, the procurement from Iran of certain military and dual use goods and services, and travel and financial sanctions against designated persons and entities who are engaged in ‘proliferation-sensitive’ activities. Since October 2008, it has also imposed additional autonomous sanctions. These include travel and financial restrictions against individuals and entities not specifically designated by the Security Council, but which contribute to Iran's ‘proliferation-sensitive’ nuclear or missile programs, or help Iran violate its obligations under Security Council resolutions. Finally, Canberra takes measures designed to counter the risk of money laundering and terrorist financing by Iran.

DFAT advises Australians considering commercial or other dealings with Iran to familiarise themselves with the operation of the Security Council Resolution-mandated sanctions regime and Australia's autonomous sanctions, and seek independent legal advice before making commercial decisions.

DR Congo – Government fights exodus of people and capital

The country suffers from stubborn conflicts in its resource-rich eastern provinces and an uncertain investment climate.

Although it produced 51% of the world’s cobalt output and 30% of the world’s diamonds in 2010, an Extractive Industry Transparency Initiative (EITI) report has calculated that the government has received only US$876 million in revenues from oil and minerals, equivalent to US-$13 a person a year.

The investment climate remains extremely difficult – ranked by the World Bank’s 2013 Doing Business survey as 181 out of 185 countries. Because of concerns about 'mining sector governance' the DRC lost its EITI candidacy status in April 2013 and the Kabila government has not yet completed a long-awaited new mining code to replace the 2002 regulatory and fiscal regime.

Violent clashes between government soldiers and rebels, often fuelled by illegal mining and smuggling, aren’t helping matters. In recent days, 66,000 refugees have fled the DRC for Uganda after the Ugandan/Congolese armed group Allied Democratic Forces (ADF) attacked the town of Kamangu. The situation remains tense as UN and Congolese armed forces increase their presence in the eastern provinces to tackle rebel groups.

Roger Donnelly, Chief Economist

Ben Ford, Senior Economist

Ignatius Forbes, Economist

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