World Risk Developments May 2013


Australia – Budget expresses guarded export optimism

Robust growth in Australia’s main trading partners should keep resource exports strong and underpin recovery in service exports, say the May 14 Budget papers.

The Budget Strategy and Outlook foresees Australia’s terms of trade declining in the medium term as the international supply of iron ore and coal increases and prices come down. But the decline is expected to be a gradual one – ¾% in 2013-14 and 1¾% in 2014-15.

Meanwhile, resource export volumes are expected to surge. Iron ore exports are forecast to increase by more than 40% over the next three years, with total volumes reaching double their 2008-09 level in 2014-15. Coal export volumes are also expected to rise strongly – 35% over the next three years. Australia is also expected to become the world’s largest LNG exporter by the end of the decade.

The biggest risk to this forecast is that commodity prices and resource investment fall more sharply than expected, as a result of slowing demand growth from China. Yet despite the signs of rebalancing in China, the country’s commodity intensity of GDP will probably remain high for a while yet as it completes its industrialisation and urbanisation.

So it seems plausible that the share of resources in Australian exports will remain higher than in the past. This might continue to put pressure on non-resource exports, although the Budget papers express some optimism about the outlook for service exports, which are expected to return to growth after an extended period of weakness. This reflects a positive outlook for inbound tourism and signs of a recovery in education exports.

Indonesia / Philippines – Ratings agencies move into line with market

Recent rating tweaks by Standard & Poor’s bring the ratings agencies more into line with market pricing of Indonesian and Philippine sovereign bonds.

S&P recently upgraded the Philippines to BBB-, its lowest investment grade, and lowered its outlook for Indonesia’s BB+ rating to ‘stable’ from ‘positive’. This follows a decision in March by Fitch to award the Philippines a BBB-, its first investment grade.

Though Indonesia has until recently outrated the Philippines, Indonesian sovereign bonds have been trading at fatter spreads than Philippine ones for years (Chart 1). The recent Philippine upgrades, however, now give the Philippines the same weighted average credit rating as Indonesia (table), and thereby serve to reduce the bond market anomaly.


Bangladesh – Shock waves from factory collapse continue

Last month’s collapse of the Rana Plaza building, where the death toll now exceeds 1000, has increased concern among international garment retailers, including Australian ones, about sourcing from Bangladesh.

Even before the tragedy, the RMG (ready-made garment) sector was suffering from strikes and industrial accidents. Most strikes have been over pay and conditions,such as one over the death of 112 workers in a Dhaka factory fire in November 2012. Twenty such strikes have gone nationwide since 2009. According to a World Bank estimate in 2001, strikes over 1995-99 cost the economy US$10 billion, or US$50 million a strike. The losses now would be considerably more.

The bitter conflict between the ruling Awami League and the opposition Bangladesh Nationalist Party has been another headache for the sector. After the Awami League decided to discontinue a caretaker government overseeing national elections and a war crimes tribunal imposed death sentences on several high-ranking members of the opposition, violent street protests have occurred, further obstructing factory operations.

How are international garment retailers reacting? Twenty-four, including major European brands H&M, Inditex, PVH, Tesco, Marks & Spencer and Carrefour have agreed to sign an ‘Accord on Fire and Building Safety’ proposed by international labour groups in mid-May. The accord is expected to cost retailers US$3 billion over five years. The majority of American retailers sourcing from Bangladesh are currently refusing to join the accord for fear of litigation. Australian retailers, including Woolworths and Wesfarmers, are also reported to be reviewing their supply arrangements. The big question now facing the industry is, Will the retailers’ unease prompt them to switch their sourcing to other countries in a bid to avoid supply disruptions and consumer condemnation of labour conditions?

The garment industry is the mainstay of the Bangladeshi economy, generating more than US$15 billion of exports in FY12, equivalent to almost 80% of total exports. It also directly employs 4 million workers. Remittances from overseas Bangladeshi workers are the second largest foreign exchange earner, at almost US$13 billion in FY12.

In 2003, Australia granted Bangladesh (and other least-developed countries) duty- and quota-free access to the Australian market. Australian energy companies are investing in gas exploration in Bangladesh. Santos is the operator of an offshore development area that will supply the Chittagong gas market.

Pakistan – New government faces economic and sectarian challenges

A raft of economic and security problems await the new government likely to be led by Nawaz Sharif’s Pakistan Muslim League, which won the largest number of seats in national and provincial elections on 11 May.

Pakistan looks likely to have its first ever democratic handover from one civilian government to another after the Pakistan Muslim League (PML) led by former prime minister Nawaz Sharif won a clear victory in national and provincial elections on 11 May. The PML won 121 seats. Though short of the 137 needed for a majority in the 272-seat National Assembly, Sharif, who twice held Pakistan’s premiership in the 1990s, should be able to reclaim power by cobbling together a coalition with some smaller parties. That should be good for stability because it means he won’t need to resort to an awkward alliance with one of his big rival parties.

The new government will face two sets of daunting challenges – one economic, the other sectarian.

On the economic side are large internal and external macroeconomic imbalances. Stagflation and stubborn fiscal budget are the main internal imbalances. The annual GDP growth of just 3% for the last five years is half the rate needed to absorb the two million new people who enter the workforce annually, while the fiscal budget for the July-June financial year will probably top 8% of GDP, compared with a target below 5%.

Meanwhile, the country is close to another balance of payments crisis – it narrowly averted one in 2008 by securing an $11 billion IMF loan package. Liquid foreign currency reserves have halved to about US$6.3 billion, equivalent to less than two months’ imports (Chart 2). In early April, the Asian Development Bank noted that Pakistan faces serious and immediate current account pressures. The Bank, along with the IMF, has been encouraging Pakistan to carry out politically sensitive reforms to strengthen the economy and widen the country’s revenue base.

Hindering the country from working off these imbalances are supply side constraints in the form of power shortages. Power cuts have increased from a few hours to up to 20 hours a day, especially in Punjab province.

The other challenge is a stubborn Taliban insurgency and worsening sectarian conflict in which hundreds have been killed in recent months.


Domestic equity investors seem largely unconcerned by these issues – the Karachi stock exchange has risen more than 17% since the start of the year. But their enthusiasm isn’t shared by foreign investors who have reduced their investments drastically from a peak of almost US$7 billion in 2008 when the government was privatising (Chart 3).

To restore confidence in the economy, the government will probably make it a priority to restart discussions with the IMF on a new loan program of reportedly US$9 billion.

Pakistan’s merchandise trade with Australia is well established but modest; it was worth $586 million in 2011.

Egypt – Economy struggles to find an equilibrium

Worsening fiscal and external accounts, and scant prospect of either financing or adjusting them, present a grim outlook.

S&P cut Egypt’s long term foreign currency sovereign credit rating in early May from B- to CCC+ amid fears about the country’s fiscal health and external financing needs. This was its sixth successive downgrade since 2011. The agency expects financing strains to remain high and external support, including from the IMF, elusive. Discussions with the IMF over a US$4.8 billion rescue package faltered in February because of an escalating political crisis. The assassination of Chokri Belaid, a leftist opposition politician, has plunged the country into fresh turmoil, and pushed back the negotiating timetable.

In response the central bank has been rationing foreign exchange, tightening capital controls, and allowing the pound to depreciate – it is down by 14% against the US$ since November (Chart 4).


In addition, the government has hastily arranged US$6 billion in external assistance from regional allies – a US$3 billion loan from Qatar, a US$1 billion credit line from Turkey and a US$2 billion deposit into the central bank from Libya. Cairo has also asked Moscow for a $2 billion loan.

These facilities will probably buy Egypt only limited time. The economy’s fundamentals have deteriorated so much that only radical adjustments and a new IMF loan will be able to restore macroeconomic balance. But with parliamentary elections due in October, such adjustments and finance are unlikely to be forthcoming. Earlier proposals, for example, to cut back fuel and wheat subsidies caused a public outcry that prompted the government to retreat.

Though Egypt is a relatively small export market for Australia, it is an important trans-shipment point in international supply chains thanks to the Suez Canal. The 192 km canal is the quickest sea route between Asia and Europe, but worries about Egypt’s economic and political security could steer some shipping traffic to Europe along the longer and more expensive Cape route.

Mexico – Economy gets its mojo back

A one notch upgrade to Mexico’s already investment grade credit rating puts it close to single-A status, assuming the Congress passes far-reaching fiscal and energy reforms.

Fitch recently upgraded Mexico from BBB to BBB+, in a move that brings it into line with Moody’s Baa1 rating. The agency noted big improvements in Mexico’s macroeconomic fundamentals in recent years. These include an absence of macro-financial imbalances, consistent adherence to inflation targeting and flexible exchange rate regimes, and strong commitment by the new administration and Congress to structural reforms.

The move by Fitch is seen by some as aggressive, particularly since the fiscal and energy reforms haven’t yet been presented to Congress. The agency’s announcement suggests it has strong confidence in the relatively new president, Peña Nieto. Such confidence could be well founded – on taking office, the president successfully negotiated with the other major political parties, PRD and PAN, a political pact (the ‘Pacto por Mexico’) in which all agreed to cooperate to advance a strong reform agenda. The Pact has produced some early wins for the president. He recently managed to push a sweeping reform bill through Congress that could open up the country’s telecom and broadcasting industries. And early in his term, he managed to carry out a substantial education reform despite his Institutional Revolutionary Party’s (PRI’s) links with the teachers’ union. Nieto also has big plans to reform the banking sector, which should boost the appeal of Mexico’s market to foreign banks – banks such as BBVA, Santander and HSBC are already big players in the country.

Macquarie Capital also has a substantial investment stake in Mexico through its infrastructure and property funds. And it plans to expand this stake, including by having the infrastructure fund invest up to US$10 billion over the next five years.

Still, getting the fiscal and energy reforms through Congress will be difficult, particularly the proposed measures to open up the state-controlled energy industry to more private investment. Successive governments have tried, and failed, to do much of what Nieto has proposed, largely because of entrenched opposition. The left-leaning PRD, for example, is opposed to changing the constitution to open up the oil industry and is sceptical about imposing a value added tax on food and medicine.

In addition, Nieto’s political ally, PAN, is internally divided. Yet PAN support is vital. Without it, Nieto’s coalition with the Green Party is unlikely to muster the two-thirds congressional majority needed to change the constitution to allow private investment in the oil industry.

The economic benefits of the reforms could be significant – more sustainable public finances and a surge in foreign investment into the oil industry would, for example, further reduce Mexico’s borrowing costs, which are already falling back towards the record lows of 2007 (Chart 5). Success might also push the ratings agencies to upgrade Mexico further.


Myanmar – Australian firms take part in FDI influx

The anticipated wave of foreign investment into Myanmar following its re-engagement with the world appears to be coming in. Manufacturing and energy are two investment destinations, and Australian firms figure prominently in the latter.

FDI reached US$1.42 billion and created approximately 83,000 jobs in the 2012-13 fiscal year ending March, the government claimed recently.

Manufacturing FDI increased 50% to US$400 million, mainly into food processing and garments. The government is promoting export-oriented industries through incentives such as tax holidays, accelerated depreciation and tariff exemptions for capital goods imports. It is also giving assurances about profit repatriation and pledging not to nationalise or repudiate licences and contracts – as the military socialist government did after the 1962 coup d’état. Mainly Asian investors are responding, led by China, Hong Kong, Japan, Korea and Singapore. They are reportedly positioning themselves for the EU and possibly the US reinstating Myanmar’s preferential trade status. This would allow Burmese exports to enjoy duty- and quota-free access to Western markets.

Though manufacturing FDI is growing rapidly, oil and gas still command the lion’s share of FDI flows and stocks, and will continue to do so for some years. There has been FDI into oil and gas since the 1980s led by companies like Total, Chevron, Petronas, Daewoo and China National Petroleum Corporation. While sanctions inhibited Western investment in this period, they didn’t totally outlaw it – EU sanctions didn’t specifically target oil and gas, and a US investment ban applied only to contracts signed after 1997. And now democratisation and sanctions-easing are allowing more firms to come in.

Among the current influx are ConocoPhillips, ExxonMobil, Chevron, BP, Royal Dutch Shell, and Statoil. Australian firms make up 12 of 59 companies selected for pre-qualification to bid for 18 onshore blocks. Woodside Petroleum entered the sector last December by buying a 40% interest in the Daewoo-led consortium developing the offshore Shwe gasfield.

It isn’t just sanctions-easing that is behind the influx, but domestic reform. The government has introduced a competitive and non-negotiable tendering process for oil and gas blocks, and also a pre-qualification procedure requiring technical and financial competence. Because of the expense and complexity of deepwater drilling, foreign bidders are being offered full exploration and development rights in 19 deepwater blocks.

Moreover, the government intends to join the EITI, or Extractive Industries Transparency Initiative. This could see it raise procurement and environmental standards for mining and energy projects, and place disclosure obligations on both investors and itself concerning the revenues they pay and it receives.

Interestingly, Senior Minister Soe Thane, a leading reformer in President Thein Sein’s cabinet, has said the government may renegotiate existing contracts as part of its EITI accession process. This will certainly unsettle junta-era investors, and perhaps even new ones. The minister’s recent resignation from the chairmanship of the government’s investment commission, though not from his ministerial position, is also causing consternation.

Canberra lifted last June its remaining targeted travel and financial sanctions on Myanmar ‘to encourage further democratic reform’.

DR Congo – ‘Opaque concession trading’ has implications for Australia

Kofi Annan’s Africa Progress Panel has suggested that ‘opaque concession trading’ appears to be costing the DRC large sums of money, and that Australia and other major players in the African extractive sector should impose greater disclosure standards on their companies to stamp it out.

In its Africa Progress Report 2013 the Panel estimates that the DRC lost at least $1.36 billion in revenues from the underpricing of mining concessions sold to offshore companies over 2010-12. In five deals examined, assets were sold on average at one sixth their estimated market value and offshore companies were able to secure very high profits from the onward sale of concession rights. The average rate of return was 512%, but climbed to 980% in one deal examined.

In each deal, the Panel determined that the DRC sold copper and cobalt assets to offshore companies linked to the Gibraltar-registered holding company, Fleurette. Fleurette is linked to Dan Gertler, an Israeli businessman close to President Joseph Kabila.

Because of opaque concession trading, the World Bank briefly suspended loans to Kinshasa in 2010, and the IMF did likewise in 2012. But after the government recently released some details on one deal, the IMF’s Congolese resident representative said the Fund could now ‘move forward’ with a new program. He warned, however, that ‘there remain weaknesses in governance and transparency’.

The Panel thinks both African governments and the G8 and G20 have responsibilities to stamp out opaque concession trading and other practices such as transfer pricing and tax evasion that they suggest deny revenue to public coffers. It urges the former to institute competitive bidding for concessions and licences, and the latter to impose ‘Dodd-Frank’-like project-by-project disclosure standards on resource companies. It specifically calls upon Australia, Canada and China, as ‘major players’ in Africa’s extractive sector, to ‘actively support this emerging global consensus’.

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