World Risk Developments March 2013

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US – Sequester needs to be kept in perspective

The sequester will be a large fiscal drag, but with the private sector reviving, it probably won’t push the American economy into another recession.

Washington lawmakers imposed on March 1 the ‘sequester’, or across-the-board spending cuts, after failing to reach a compromise on fiscal reform. Unless replaced with an alternative fiscal plan, the sequester will cut federal spending by US$85 billion during 2013, and US$1.2 trillion over the next decade.

Economists almost unanimously agree that cutting public spending in an economy stuck in a liquidity trap, as the American economy is, will impose a large drag on real GDP growth. According to forecasts by the non-partisan Congressional Budget Office, real GDP growth in 2013 will be 1.4%, 1.5% points lower than would be the case without the sequester and tightening measures adopted in January.

Even so, there are grounds to believe that the economy will be able to withstand the sequester without falling into a slump. These include lean business inventories, a marked strengthening of household balance sheets, a recovery in housing (both rising prices and falling inventories) and improved credit availability. Together these factors are giving the private sector an impetus that should more than offset the headwinds from the sequester (Chart 1).

The outlook wasn’t always this positive. Late last year, most analysts foresaw a risk of renewed recession, because the economy was then travelling at ‘stall speed’.

It is possible that the economy could still fall over another fiscal cliff in May when the federal ‘debt ceiling’ must again be raised. But another round of brinkmanship similar to the one in August 2011, which cost the United States its AAA rating, seems less likely, with polls suggesting most Americans favour a compromise.

Japan – ‘Abenomics’ should provide some support to a weak economy

Whereas the sequester is a drag on a reviving American economy, ‘Abenomics’ aims to spur a sluggish economy.

The Japanese economy lapsed back into recession in late 2012, and ‘Abenomics’ (named after newly elected Prime Minister Shinzo Abe) may struggle to revive it. Even the fall in the yen may be unable to stimulate much export growth if relations with China remain strained.

Nevertheless, the extra spending promised by Abe, with cooperation from the Bank of Japan to provide the necessary monetary financing, should create some spur to activity and may succeed in relieving fears of continuing deflation.

The risk of a sovereign debt crisis is small. Thanks to strong domestic support for public debt, the government should be able to cope with a temporary return to fiscal stimulus.

As with all fiscal stimuli, the concern is more that once this one ends, growth will subside again unless the stimulus succeeds in reviving private sector demand growth.

Italy – Indecisive election result increases uncertainty

The impasse produced by the election has increased fiscal risks.

The general election last month produced a hung parliament – a coalition of centre-left parties led by Pier Luigi Bersani gained the most votes and a lower house majority, but the anti-establishment Five Star Movement led by the comic blogger Beppe Grillo gained the third largest vote and the balance of power in the senate. Slightly behind the centre-left with the second largest vote was Silvio Berlusconi’s centre-right coalition. In fourth place, with less than 10% of the vote, was the incumbent centrist party led by Mario Monti.

The poor showing by Monti indicates the depth of voter anger with his policy of fiscal austerity. In all, 60% of voters supported parties repudiating his approach.

The snag now is, Italy lacks a government because the rules say a government needs a majority in both houses. The centre left has asked the Five Star Movement to join them in government, but Grillo has said he will support none of the established parties. Before the election, the odds-on favourite to form government was a loose coalition between the centre left Democrat Party and Monti’s party. But Monti ran so poorly that he didn’t get sufficient seats to make this possible. There may thus need to be a fresh election, but this can’t happen before June for constitutional reasons.

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The election has made markets jumpy (Chart 1). If they deny the government access to the bond market, a liquidity crisis could ensue. Alternatively, they could demand higher interest rates of the government, causing the public debt to snowball, which eventually leads to a solvency crisis. One can object that these scenarios are too far-fetched. After all, markets are used to frequent changes of government: Italy has seen 62 governments since the Second World War. Besides, the government can head off such dangers by asking the European Central Bank to buy bonds under the Bank’s outright monetary transactions (OMT) facility. It could even approach the EU for a bailout loan under the European Stability Mechanism (ESM). Ultimately, it could ask for a debt writedown as Greece has done. But clinching OMT/ESM support could prove tricky, because both facilities come with strings attached, including ones about fiscal austerity, and as the markets have registered, Italian voters currently have a strong case of austerity fatigue (Chart 2).

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Philippines – Mining becomes poll issue

Mining has become a vexed issue in the campaigning for the mid-term gubernatorial and congressional elections in May, pitting the central government against provinces, local religious leaders, green groups and indigenous tribes.

The governor of South Cotabato province in Mindanao, Arthur Pingoy, recently insisted that his government’s ban on open-pit mining would stay even though the central government had granted an ‘environmental compliance certificate’ to Xstrata’s much-delayed US$5.9 billion Tampakan copper and gold mine in his province.

The Tampakan deposit is South-East Asia’s largest, and the mine the Philippines’ biggest foreign investment. Xstrata holds 62½% of the project and has management control through its Philippine subsidiary, Sagittarius Mines. Australia’s Indophil Resources is the junior partner with 37½%.

The three candidates for the South Cotabato governorship, including Pingoy, are likely to adopt anti-mining platforms under pressure from local religious leaders, environmentalists and indigenous tribes, and to set themselves apart from Manila.

An executive order from the president last year tried to overturn the local mining bans, but the provinces defied him. At least 14 have issued ordinances against mining.

Opposition from the provinces could begin to soften after the elections. Nevertheless, investment is still likely to be held back till a mining revenue sharing law is passed and a moratorium on new investments lifted. The mining industry has been complaining that these hold-ups have caused a loss of US$1.5 billion in potential mining investment.

Venezuela – Will the death of Chavez spell the end of Chavismo?

Not necessarily.

There has been some speculation in financial media that President Hugo Chavez’s death from cancer on March 5, could spell the end of the Bolivarian Revolution he introduced when he became president in 1998. A 6 March ft.com video, for instance, speculated that the death ‘probably heralds some opportunity both for the national oil company and for foreign oil majors’.

But Vice President Nicolas Maduro, Chavez’s chosen successor, is in a strong position to win a presidential election that will be convened in 30 days. He will benefit from the government’s entrenched majority, a sympathy vote for Chavez, and discipline and unity within the Chavista party machine. In contrast, the opposition MUD party lags behind in popularity, and is having little success gaining ground. In the October presidential election, its candidate lost by an 11% point margin to Chavez. In elections for regional governors in December, it was again defeated. Finally, in a recent opinion poll, Maduro showed a lead of more than 10% points over the opposition candidate.

Importantly, Maduro is rallying his supporters by promising to be the guardian of Chavez’s legacy.

Might economic necessity nevertheless force him to change his tune? Certainly the economy is under strain. Overvaluation of the bolivar is a pressing concern and forced the government last month to carry out a 32% devaluation, which was praised by the IMF as a positive step to reduce macroeconomic imbalances. The devaluation will reportedly relieve pressure on the fiscal dExport Finance Australiait (equivalent to 11% of GDP), increase state’s net revenues by 4% of GDP, reduce the value of domestic debt from US$43 billion to US$29 billion, and raise the value of oil export earnings.

But it is also harming profits and shares of US and European companies such as Colgate Palmolive, Haliburton, Avon and Spain’s Telefonica. One issue is a cost-price squeeze: profit margins are being caught between rising bolivar import costs and prices fixed by government controls. The devaluation will also add to inflation, which at 23% is close to the highest in the world.

At least in the short run, the Chavista economic model looks sustainable, even if it has to be shored up with price and exchange controls and other regulations unfriendly to business.

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