World Risk Developments November 2013

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US – More fiscal cliffhangers possible

Last month's budget deal is a temporary one only. When it expires, more battles are possible on Capitol Hill, quite possibly causing further shutdowns, if not a default.

As expected, the US government didn't in the end default last month. The Senate and House of Representatives passed legislation on October 16 to fund the government and suspend the debt ceiling, heading off a possible 'voluntary' sovereign debt default.

But that isn't the end of the story. The deal is only short-term – extending funding to January 15, 2014 and suspending the debt ceiling till February 7. And the bitter partisanship that marked the recent budget battle looks set to continue in 2014. So there is the possibility of further budget battles starting early next year.

Luckily, the threat of default has diminished for two reasons. The first is its unpopularity. Because of Republican brinkmanship on the debt ceiling, the party’s approval ratings have dropped sharply. It therefore seems unlikely to resist ceiling increases in the lead-up to the 2014 mid-term elections.

The second reason is a little-reported aspect of the legislation called the Default Prevention Act of 2013. This will allow the president to veto any decision by Congress not to raise the debt ceiling, unless Congress can come up with a two-thirds majority to over-ride his veto. In other words, the ceiling will be raised as long as the president has the support of one third of Congress, which he does. Although this procedure will lapse on February 7, there are hopes that it will be made more permanent, using the many precedents for giving the president authority to act unless over-ruled by a two-thirds Congressional vote.

Hitting the debt ceiling wouldn't just push the government toward default; it would also require it to balance its budget at once. This would entail a fiscal adjustment of 4% of GDP, since that is the size of the dExport Finance Australiait. Though such a large retrenchment now looks unnecessary, the prospect of further shutdowns still needs to be faced.

The October 1-16 shutdown will perhaps shave 0.6 percentage points off annualised December quarter growth. Helping to limit the damage is the fact that federal employees will receive back pay and all contracts will be honoured.

Future shutdowns may show similarly limited fiscal drag, but will impose less tangible indirect costs, particularly by damping business confidence.

Ultimately, the inability to reach fiscal compromise comes from implacable differences between the Democrats and Republicans over how to restore the US budget to long-run sustainability. Democrats note that almost US$2 trillion of spending cuts have been carried out under a sequester forced on them by Republicans; they want further dExport Finance Australiait reduction to come through revenue increases. Republicans meanwhile insist that dExport Finance Australiait reduction must be through spending cuts alone.

China – Ambitious reform plan aims to revive flagging growth

The Communist Party's new economic reform agenda is ambitious and sensible, but will challenge vested interests and the Party's political conservatism, and conflict with the goal of sustaining short-term growth.

The Party released on November 15 a comprehensive 60-point reform blueprint for consideration and implementation during President Xi Jinping’s leadership term. Grabbing media headlines were its decisions to relax the one-child family planning policy and abolish the ‘laogai’ prison labour system. But it also included a raft of economic reforms, including: greater scope for the private sector and market-based resource allocation, financial and state enterprise deregulation, greater respect for property rights including environmental ones, and reassignment of spending and taxing responsibilities between different levels of government. While the economic measures are broadly liberal, the political ones are more mixed, and include things like tightening internet control.

The blueprint’s release comes at a time when the economy has reached a turning point. The old economic model that relied on cheap labour, exports and investment to drive growth has become ‘unbalanced, uncoordinated and unsustainable’, to use Mr Xi’s words. The economic reforms are being widely interpreted as the Party’s attempt to find a new model – one that will overcome China’s macroeconomic, demographic and environmental challenges so that it can ‘grow rich before it grows old’.

The blueprint is bold and well-focused. Where doubts crop up are in three areas. The first is, Will it be implemented in the face of opposition from special interests among state-owned enterprises, local governments and property developers? The second: Will the plan’s political conservatism clash with its economic liberalism?

The third: What will happen if the economy slows sharply? Premier Li Keqiang recently said that GDP growth of 7.2% was necessary to create 10m jobs each year and keep urban unemployment at 4%. These and other similar statements by party leaders have given rise to the suspicion that if growth falls below this level, the government will carry out investment-led stimulus in opposition to its plans to downplay investment and encourage consumption. This concern is a little exaggerated, because there is plenty of worthwhile investment that can still be done that doesn’t involve adding to existing over-capacity.

Philippines – Economy will withstand typhoon

As extensive as the damage from Typhoon Yolanda has been, the economy is likely to prove resilient.

The typhoon could well be the worst in Philippine history – disturbing almost 11m people, or more than 10% of the 97m population, in eastern and central Visayas in the centre of the country. For many of the worst-hit provinces, trouble came in fours. On October 5, there was a preliminary large typhoon, then on October 15 a 7.2 scale earthquake, then on November 8 Yolanda. Following Yolanda, tropical depression Zoraida dumped more rain on November 12-13.

The latest estimate of the death toll is close to 7,000, a number approaching that from the country’s most deadly disaster, a tsunami in the Moro Gulf in 1976, which killed 8,000 people.

Early estimates of damage go up to US$15b, or more than four times the nominal cost of all the typhoons over 1997-2007. The cost would have been higher were it not for the Philippines’ widespread poverty, which means that much housing in the affected region consists of inexpensive nipa huts made of wood, bamboo and thatch. Also limiting the losses was the fact that the typhoon didn't strike the more densely populated and developed Luzon island to the north, or the two largest Visayan cities, Cebu City and Bacolod (at least with full force).

Housing and infrastructure aren't the only things to have been damaged; farms, fishing boats, tourist resorts, warehouses, workshops and shops have been, too. According to the Department of Agriculture, 130,000 tonnes of rice and 50,000-100,000 tonnes of sugar have been destroyed.

Finance Secretary Cesar Purisima has estimated that GDP in the Visayas, which before the typhoon was almost 13% of national GDP, could fall as much as 8% in 2014.

So there is no doubt that the typhoon will be a large setback to production. There will, however, be three factors helping to cushion the economic impact.

  • Fiscal space. The government has strong finances, which have recently won it investment grade credit ratings. It has announced it will moderate its fiscal consolidation program and allocate funds to reconstruction.
  • Remittances. OFWs, or overseas Filipino workers, who make up one in four of the workforce, or 10.5m people, and remit US$18b-19b pa back to their homeland, are likely to up remittances, though they are having difficulty doing so now because money transfer services are still down in remote townships. This money will help to pay for imports needed for reconstruction.
  • Aid. More than 30 countries and international organisations have pledged immediate relief aid, grants and loans.

The increased government spending, along with remittances and aid, will finance reconstruction, which will compensate for the output lost due to the typhoon. Some of the aid, including funds from a US$500m World Bank loan, will go towards paying people whose livelihoods have been destroyed by the typhoon to clear debris and rebuild.

India – Disinvestments prompt government response

A recent spate of high profile foreign disinvestments has prompted New Delhi to relax foreign investment rules, make international arbitration easier, and promise banking deregulation.

The country has recently seen several international companies withdraw from joint ventures with Indian companies, citing an increasingly difficult regulatory climate. Walmart recently ended its joint venture with Bharti after striking difficulties with local content rules and investment restrictions. Posco, ArcelorMittal and Berkshire Hathaway have also sold investments. Among miners, BHP Billiton has pulled out of several promising exploration ventures. These disinvestments are taking place against a backdrop of falling FDI inflows, a rupee under pressure and a slowing economy.

But the ill wind seems to blowing some good. It has prompted the government to ease foreign investment restrictions for defence, energy and single-brand retail firms, and open telecoms to 100% foreign ownership.

There has also been a push to make independent arbitration more attractive to domestic companies as a means of dispute resolution. Courts have been allowing international arbitration tribunals to operate and narrowing the grounds on which domestic courts can overturn their decisions. This is likely to be welcomed particularly by companies such as McDonalds, BG and Reliance Industries with arbitration cases pending.

Finally, the new central bank chief Raghuram Rajan has promised a ‘dramatic remaking’ of the banking industry, including an expanded role for foreign banks.

Egypt – Gulf aid eases financial strains

A US$12b aid package from Gulf states has boosted the economy and strengthened public finances.

The government is believed to have already received $7b in interest-free deposits and more than US$1b worth of petroleum products from Saudi Arabia, Kuwait and the United Arab Emirates. Data from the Ministry of Finance suggests that US$1b has also gone directly into the budget as a grant. The receipt of these funds has enabled the interim government installed by the army in July to repay US$2b of US$5b that the previous Muslim Brotherhood government received from Qatar in the months before the coup. It has also enabled the government to reject a $4.3b loan from the IMF.

The aid has had several favourable effects – increasing foreign exchange reserves and strengthening the pound, enabling the central bank to lower interest rates, and cutting the government’s interest costs and fuel subsidy bill. It has also allowed the government to embark on a modest package of capital spending amounting to US$4.2b in the current fiscal year, which has in turn improved the economic outlook. More ambiguously, it has allowed the finance ministry to ease off on fiscal retrenchment and structural reforms such as cutting energy subsidies.

The resultant strengthening of the economy and public finances prompted ratings agency Standard & Poor's to upgrade its long-term credit rating of Egypt to B- from CCC+ on November 15.

The government is now reportedly discussing with its Gulf donors a second program to support investment rather than current spending. It is also in continuing talks with the IMF, World Bank and other international agencies about a possible loan to support structural reforms.

Roger Donnelly, Chief Economist
rdonnelly@exportfinance.gov.au

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