World Risk Developments April 2014


Emerging markets, Greece and Russia in the spotlight

Emerging markets stage comeback

Concerns about an emerging market crisis are waning as foreign portfolio investors begin to invest in these markets again.

The markets have suffered a couple of selloffs over the past year — over May-July 2013 and at the start of this year (Chart 1). They occurred because investors became worried about the prospect of rising interest rates in advanced economies and growing economic imbalances within certain markets, particularly the ‘Fragile Five’ — Brazil, India, Indonesia, Turkey and South Africa. Suddenly, ‘reaching for yield‘, didn’t sound like such good idea. Still less did ‘carry trading’, which involves borrowing cheap money in advanced economies to invest in higher yielding emerging economies. The resulting selloffs were so severe that concerns arose about another emerging market crisis — Asia yu all over again.


But investors appear to have regained their appetite for these markets in the last two months, because of a reversal of the previous concerns. Whereas US Federal Reserve talk of ‘taper’ last year hadled them to believe that interest rates would rise quite rapidly, subsequent assurances that ‘tapering isn’t tightening’ has led them to temper their rate rise expectations. Interest rate expectations have also come down in the euro area as the European Central Bank has begun to toy with the idea of quantitative easing. Finally, market participants have become more hopeful about the prospects of adjustment in emerging markets themselves. So portfolio investment has started to flow back in, and markets have rallied. So much so that India and Indonesia have become two of the best performing stock markets in the world this year (Chart 2).


Elections influence market sentiment in "Fragile Five"

National elections are taking place in each of the Fragile Five this year. Markets seem to be responding positively to the prospect of reformists being elected in India and Indonesia. But even in Brazil, Turkey and South Africa, where incumbents look more secure, they have rallied.

Elections are underway in both India (legislative) and Indonesia (legislative/presidential). In India, markets are pinning their hopes on Narendra Modi becoming prime minister, and in Indonesia on Joko Widodo becoming president. Both have developed a reputation for being can-do men in their previous jobs. As chief minister of Gujarat, Modi boasts running a state where the ‘water is clean and the electricity runs 24 hours a day’, which has purportedly enabled his state to outgrow the Indian average over his term of office. Widodo, as mayor of Jakarta, meanwhile gets praise for having ‘cut through red tape and shame[d] local officials’.

A legislative election is also scheduled to take place in South Africa in May, and presidential elections in Turkey in August and Brazil in October. No electoral rally is evident in any of these countries, because incumbents there lead opinion polls, and markets are expecting more of the same. Even so, they have recovered in each of these countries as well, and the reason seems to be that central banks have increased official interest rates sharply.

The improvement in market sentiment seems to reflect a judgment that the Fragile Five can withstand a gradual rise in advanced economy interest rates, even where entrenched incumbents are conducting business as usual. This is probably correct as we have argued here.

Nevertheless, there appears to be plenty of scope for further selloffs. Modi and Widodo haven’t yet clinched victory, for instance. And even if they succeed, they will have to work with fractious parliamentary coalitions and disagreeable regional governments that could well undermine them. In Turkey, political instability is increasing, prompting Moody’s to lower its outlook for Turkish sovereign debt to ‘negative’ from ‘stable’. Finally, in both Brazil and South Africa graft is becoming an election issue.

Greek bond market return is no sign default risk has vanished

The Greek government’s recent successful return to the international bond market shouldn’t be taken to mean that fiscal solvency has been restored. Far from it: the government is quite probably going to need significant further debt writedown.

Athens raised 3 billion euros in five-year bonds at an interest rateof 4.95% earlier this month — its first venture into the international bond market in four years. It reportedly received 550 bids of more than 20 billion euros, mostly from foreign investors. The sale went ahead in spite of a car bomb blast near the Bank of Greece and a 24- hour strike against the government’s austerity policy.

The return to the bond market is sooner and on better terms than most had expected. At a time of low yields, investors have evidently been willing to overlook Greece’s 2012 default for the fairly lucrative return on offer.

They must surely not be judging that the government has returned to solvency, because public debt is still an enormous 175% of GDP, and rising, even after draconian austerity for four years. Instead, they seem to be gambling that any further debt writedown will take place after their bonds mature in five years. Or failing that, official
creditors holding three quarters of the Greek public debt, will agree to take a haircut, leaving private bondholders unshorn.

This is a debatable assumption. Officially held public debt is so high now, precisely because official creditors (in the EU and IMF) refinanced much of the Greek public debt in 2010 and 2011 when private bondholders were refusing en masse to roll over. The official creditors in effect socialised a lot of the public debt, and let many private bondholders thereby escape scot-free. In these circumstances, will the official sector be inclined to feel sorry for
remaining private bondholders come the next writedown?

Ukranian crisis pushes Russia to the brink of recession

The Ukrainian crisis seems increasingly likely to push an already sluggish Russian economy into recession this year and next.

Even before the onset of the crisis, the economy was sluggish, owingto weak investment, slow recovery in the world economy and the pullback by portfolio investors from emerging markets (see first story). It probably grew at only 1.4% in 2013.

And then Russia annexed Crimea in March. This is exerting a variety of drags on the economy — through capital flight, credit tightening, and blows to consumer and investor sentiment.

The weakest drag is actually sanctions, because such sanctions as have so far been announced are piecemeal, and in many cases have yet to be implemented.

In its latest World Economic Outlook released this month, the IMF foresees Russian GDP slumping by 0.6% in 2014 and 0.2% in 2015. It adds that the balance of risks remains to the downside and worries in particular about an ‘intensification of sanctions and countersanctions [that] could affect trade flows and financial assets’.

Dubai continues to work off its debt overhang

With Abu Dhabi’s help, Dubai is continuing to work off its debt overhang.

This overhang suddenly became apparent at the peak of the financial crisis in 2009 when Dubai’s debt-laden government-related entities (GREs) struggled to attract international finance. To help it out of its difficulties, Dubai sought Abu Dhabi’s help to roll over existing debt.

While the debt workout is proving effective, it is not over yet. In March, Abu Dhabi and the UAE central bank refinanced US$20b of debt which was extended to Dubai as emergency aid during its debt crisis (including a US$10b loan through two state-owned banks and US$10b in bonds owed to the UAE central bank). And that isn’t
the end of the story. According to the IMF, Dubai and its GREs owe repayments of US$78b before 2017 on a total debt stock of US$142b.

They reportedly plan to make asset sales to clear some of this debt. They are also expected to receive from Abu Dhabi further rollovers, equity injections and debt forgiveness to help them through.

The support from Abu Dhabi together with recovering asset prices, improved liquidity conditions and a healing world economy are enabling the GREs to gradually resolve their debt problems. This has in turn helped the Dubai economy get back onto its feet. While in 2009 it contracted by 4.8%, by 2011 growth had rebounded to 3.9%.
The IMF is forecasting 4.4% growth in 2014.

Can Nigeria double its GDP to a trillion dollars over the next decade?

An official recalculation of GDP suggests that Nigeria has a larger economy than South Africa, and could join the exclusive club of countries with an annual GDP greater than US$1 trillion in a decade, if it sustains its current 7% growth rate.

Previously it was thought that South Africa was the No.1 African economy with a GDP of US$351b and Nigeria No.2 with a GDP of $US286b. But the recalculation suggests that Nigeria’s GDP was actually US$510b in 2013 — and its per capita income US$3,018 rather than US$1,595.

Since growing at 7% pa doubles the size of an economy in just over 10 years, Nigeria could join the ‘trillion dollar club’ by 2024 (Chart 3).

Is 7% pa growth kept up for a decade likely? It is certainly possible. There are cases of countries starting with per capita GDP as low as Nigeria’s – $US3,018 – and doubling their GDPs over a decade or less, then doubling them again in the next decade. China, Japan and South Korea are examples.

Nigeria is promising to be the first African country to do so. It has grown at 8.2% pa since 2000 and if the IMF’s forecasts of nearly 6.9% pa growth until 2019 hold, it will have a 20 year compound average growth rate of 7.8%.

The revelation that Nigeria is bigger, richer, more dynamic and more diverse than previously thought may prompt investors to look at the country in a fresh light, especially the rapidly growing construction, manufacturing, mobile phone, film, music and financial service industries.


Cuba's new foreign investment law courts big investors

Cuba passed a new foreign investment law on 29 March in what looks like the second step on a slow march towards market capitalism.

The old foreign investment law enacted in 1995 attracted only disappointing levels of foreign capital. The new law attempts to tackle the economy’s need for large-scale investment in infrastructure and other industries.

Foreign investment is to be permitted in all industries except health, education and the armed forces. Profit tax will be halved, new investors will be tax exempt for eight years, and repatriation of profits will be permitted. Expropriation will be banned except in cases of public interest. In such cases, appropriate compensation will be paid according to commercial value and by mutual agreement between investors and the government.

The new investment law signals a second phase of reforms. Phase- I allowed almost 500,000 Cubans to gain licences to operate small private businesses. There are other reforms underway or in the works too. In December 2013 the government confirmed that it would gradually eliminate the dual currency system, though details are
scarce. Currently, the hard currency-based ‘Convertible Peso’ is pegged to the US dollar and reserved for tourism and foreign trade, while most Cubans are paid in the Cuban Peso — worth about 4 cents each.

In January work was begun on the Mariel Special Development Zone — a US$1b infrastructure project largely financed by Brazil, which will handle larger ships that transit the Panama Canal. The Mariel zone provides foreign firms with tax breaks and flexible labour contracts exceeding those offered under the new foreign investment law.

Economic reforms have spurred negotiations with the EU for a cooperation agreement and helped to moderate tensions with Washington. They are likely to result in increased foreign investment, boosting the struggling economy and helping to update its industrial base.

Roger Donnelly, Chief Economist

Cassandra Winzenried, Senior Economist

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