Negotiations between Greece and the Brussels Group are not tracking well. The Syriza-led government continues to refuse austerity measures, while the IMF is holding firm on demands that Greece make good on fiscal reforms to receive further assistance. If an agreement cannot be reached, Greece will forgo US$8.4b in bailout funds it requires to pay creditors — starting with US$835m due to the IMF in early May.
Not surprisingly, markets have reacted negatively to the breakdown in negotiations. Yields on Greek 10‑year government bonds have risen from 5% in September to over 13% reflecting higher risk premiums, while interest rates on debt due in 2017 are at a record high 28%.
How could the Greek situation play out and what are the implications for Australian exporters? There are three scenarios: First, a temporary compromise is reached, the status quo remains and Greece continues to muddle along — with no impact on Australian exporters. But because Greece is unwilling to accept austerity, the odds of this scenario are lengthening. Indeed, the German Finance Minister has said “Nobody expects that there will be a solution” ahead of the leaders’ meeting last week.
Second, Greece defaults on its debt but remains in the eurozone with the ECB continuing to provide support to the banking sector. Defaulting on external private debt holders is unlikely because Greece may need to return to capital markets in the near future. The likelihood of default on debt held by fellow eurozone governments is also low given that the first tranche of repayments isn’t scheduled until 2020. Defaulting on citizens by not paying wages, invoices and pensions is unlikely due to political and social costs. This leaves debt held by the ECB and IMF, collectively worth around US$61b (Chart 1). Under this scenario, the ECB would support Greece’s cash-strapped banking sector — under emergency funding guidelines — to minimise the fallout across the region. The Greek government would need to institute deposit freezes and capital controls to prevent bank deposits leaving the country. This could cause flutters in European financial markets as investors turn their gaze to other highly indebted eurozone countries. But the ECB’s quantitative easing and other emergency measures provide a firewall, minimising the negative impact on financial markets and global demand.
The third scenario is the most damaging — Greek default and eurozone exit. In this scenario Greece defaults on its IMF and ECB debt and the ECB withholds support for the Greek banking system, forcing a banking crisis. Greece adopts its own currency, which would depreciate significantly against the euro and automatically raise the value of foreign currency denominated debt, putting further financial strain on banks, households and companies. The European financial system and the vulnerable economies of Spain, Italy and Portugal are now in a better condition to weather a ‘Grexit’. But investors would still question the integrity of the eurozone, causing gyrations in global financial markets with negative spillovers to the European recovery and global economy. Australian exporters would face higher short term trade finance constraints, while the drag on global growth would stunt the demand for Australian exports.
EM economic frailty and financial vulnerability
The IMF’s World Economic Outlook released this month highlights the Fund's expectation of a prolonged period of low global growth, led by emerging markets. While risks to growth have receded since October, the IMF cautions that risks to global financial stability have risen.
IMF analysis suggests that the financial crisis merely exacerbated a slowdown already underway in potential growth among advanced economies. While expected to increase slightly from current levels, potential output growth will remain below pre-crisis rates (Chart 2). The main culprit for long term potential output losses: slower investment and ageing populations. In contrast, the slowdown in emerging markets began only after the crisis and the decline still has further to run (Chart 3). The main constraints here are ageing populations and falling productivity as these countries come close to achieving technological catch-up. China’s potential growth in particular could fall sharply as it shifts away from investment towards consumption.
The IMF calls for policymakers to stimulate demand, and thereby avoid ‘secular stagnation’, via infrastructure spending and measures to increase productivity. However, the urgency for structural reform looks to have dissipated, with many economies instead relying on low interest rates and exchange rates to stimulate growth.
As for financial markets, the IMF cautions that a ‘super taper tantrum’ could emerge as the US Fed normalises interest rates. The IMF worries about a sudden spike in yields once the reality of the first US rate hike in nine years dawns on markets. ‘Shifts of this magnitude can generate negative shocks globally, especially in emerging market economies’. Investors have already begun to recoil — emerging market capital outflows reached their highest level since 2009 at the end of 2014. The Institute of International Finance thinks an increase in risk aversion would disproportionately affect countries more integrated into international financial markets and dependent on external financing. Countries that fit the bill include Russia, Brazil, Mexico and Turkey.
Emerging markets are increasingly vulnerable to higher US interest rates given a growing exposure to USD-denominated corporate debt — debt grew faster than GDP in all major emerging markets over 2007 to 2014. Foreign currency reserves held by emerging markets also registered their first annual decline last year since records began in 1995. In addition, the IIF’s EM Coincident Indicator suggests emerging markets suffered their slowest pace of growth since 2009 in the last quarter. The Brookings TIGER indices also reveal slower GDP growth, declining consumer and business confidence, and weak export growth. Higher debt, lower reserves and slowing growth reduce the fiscal space available to pay debts, rebuild budget surpluses and spend on infrastructure and corporate expansion.
These factors also lower fiscal safeguards during future slowdowns. In China, some analysts are warning that a speculative stock market bubble that could create a 'black swan' event in China's financial system. China’s stock market has doubled over the last 12 months, with investors opening more than 4.8m new stock trading accounts in March alone. Additional regulatory measures have been announced — including tightened rules on margin lending — but an aggressive monetary easing cycle meant to counter the economic slowdown will fuel exuberance.
Iran sanctions relief to damp oil prices
Iran and P5+1 world powers have agreed the terms of a deal to curb Iran’s nuclear program in return for sanctions relief. Iran’s ‘breakout capability’ — the time required to make an atomic bomb — would be extended to one year and an intrusive inspection regime applied. Any resultant sanctions rollback would spur Iran’s economy and oil exports — with important implications for already oversupplied global oil markets and Australia’s exports to this large and diversified market.
Critical technical details still need to be hammered out before a comprehensive accord can be agreed by a 30 June deadline. A sceptical US Congress will also have the opportunity to reject the final agreement, but prospects for gradual sanctions reduction look positive.
Sanctions have reduced Iran’s crude exports to about 1.1m b/d — half their pre-sanctions level. Dismantlement is likely to be a slow process that results in oil output rising slowly from 2016. The International Energy Agency expects that 0.8m b/d of Iranian oil could return to the market at this time. In addition, 30m barrels of crude in floating storage are primed for market before then. For the already oversupplied market this will mean continued low prices in 2016 and 2017. While markets still expect prices to increase over 2016, the US Energy Information Administration estimates that 2016 prices could be US$5‑15 a barrel lower than they otherwise would have been with full-blown sanctions. This is based on the expectation that the rest of OPEC is highly unlikely to curtail output to accommodate new Iranian supply.
But longer term, while Iran has the world’s fourth largest oil reserves and largest gas deposits (Charts 4 and 5); its fields are in long term decline. After a five year absence, foreign technology and expertise will need to return to the country to maintain and expand capacity. Despite favourable geology and low production costs, Iran will face challenges in attracting this investment. The world market is characterised by sharply lower prices necessitating fierce downsizing by energy majors, while Iran’s business climate remains unfriendly. Oil and gas laws do not allow foreign ownership, but instead reward international investors with a slice of revenues. While authorities say this regime will become more favourable, further details will be needed to convince foreign companies.
Opportunities for exports to a newly approachable Iran are large. The country’s large population and diversified economy is already attracting senior business delegations. Australia exported goods worth $360 million to Iran in 2014, which has traditionally been a major wheat buyer. Other Australian exports to Iran include meat, dairy products and wool. Opportunities for Australian firms could also emerge in consumer goods, mining services and infrastructure development.
Egypt’s improving prospects stoke investment
The political uprising of 2011 caused widespread economic pain. But a 'new economic vision' launched by President Abdel Fattah El Sisi has improved prospects. This culminated in last month’s Economic Development Conference which reportedly yielded US$60b in investment contracts and pledges.
After four years of turmoil, Egyptian authorities are implementing ambitious fiscal and economic reforms to boost growth and attract foreign investment. The IMF reckons these policies, along with some recovery in confidence, are starting to produce a turnaround. Growth that averaged only 2% over the past four years is expected jump to 4% this year (Chart 6). Moody's has upgraded Egypt's credit rating on expectations of continued political stability and improved business conditions. Structural reforms and investment promotion aim to raise economic performance, and fiscal consolidation to bring finances under control by slashing fuel subsidies and raising tax revenue.
At the core of the government's strategy to attract FDI is the launch of high profile mega-projects — including the Suez Canal Development Project and construction of a new US$45b capital city 700km east of Cairo. These initiatives featured at a major investment forum held in March that reportedly secured over US$60b in signed contracts and other contributions. Traditional Gulf allies pledged US$12.5b in official aid and investments, while contracts and loans from international financial institutions totalled US$5b. BP also signed a US$12b West Nile Delta natural gas development deal — expected to produce around 25% of Egypt's current gas production. Other investment deals and pledges reportedly include US$10.5b with Siemens and US$5b with Italy's Eni.
The conference was also used to unveil a highly anticipated ‘unified investment law’ which aims to create a one-stop shop for investment procedures and a resolution mechanism for disputes.
But the challenge of economic revival can’t be underestimated. In President Sisi’s words ‘even running will not be enough’. Egypt ranked 112 out of 189 economies in the World Bank’s 2015 ease of doing business gauge, reflecting prolific red tape and poor contract enforcement. A return to the international bond market planned for this year will be the next big test of investor confidence.
Australia’s mainly agricultural exports to Egypt fell 15% over the three years to 2014 (Chart 7). But an improved economic outlook bodes well for re-establishing this export market.
Bangladesh unrest poses risks to agricultural exports
Political stability in Bangladesh has deteriorated significantly over the last three months jeopardising Australian agricultural exports.
Violent protests between supporters of the two major political parties escalated in the opening months of the year. The ruling Awami League ran virtually unopposed in the 2014 elections after its major rival, the Bangladesh Nationalist party, boycotted the vote. The BNP have since urged supporters to halt road, rail and river transport indefinitely and demand fresh elections. This has sparked violent outbreaks, with at least a 100 fatalities.
The blockades will weigh on shipments of goods and services within Bangladesh, while violence is crimping consumer and business confidence and spending. The sharemarket is amongst the worst performing in Asia, down 10% over the year to date. Political violence is likely to continue in coming months as protestors clash. The disruptions could shave up to 2 percentage points of 2015 growth, currently projected at 6.3%.
Bangladesh has a long history of political violence and scores poorly on global rankings of governance. Even so, the country is Australia’s second largest market for vegetables behind India, and also buys significant amounts of cotton and dairy products (Chart 8). The transport blockades could undermine delivery of Australian exports to their customers and raise the risk of food spoilage.
Thawing Cuban-US relations pose upside for exporters
The US and Cuba are taking steps to normalise diplomatic and economic relations. But the benefits to Australian exporters won’t be realised until the 50-year trade embargo is lifted. This is unlikely to happen any time soon.
Official dialogue between the US and Cuba began last December and has progressed to the point where Cuba will probably be removed from the state sponsors of terrorism list. This would allow it greater access to international capital markets.
The trade embargo will remain in place, but US businesses are nonetheless excited about prospects, with New York governor Andrew Cuomo recently leading a trade mission to Cuba. The population of 11 million has vast infrastructure needs and liberalising foreign investment laws present opportunities for both exporters and investors.
Australia does not have sanctions against Cuba. But trade and investment has been limited because companies with US operations would be penalised for dealing with Cuba under the terms of the US embargo. Australian exports to Cuba were worth A$4.9m in 2014, consisting mainly of electrical circuits, ships and boats. Trade with Cuba will remain crimped as long as the US trade embargo remains in place. Congress is the only authority that can lift the trade embargo and given it is controlled by the Republican Party; it appears unlikely the ban will be lifted anytime soon.
Cassandra Winzenried, Senior Economist
Fred Gibson, Economist
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