World Risk Developments August 2015


Emerging markets vulnerable to rising US interest rates

Higher US interest rates pose risks to financial stability in emerging markets. But most regional emerging economies, except Indonesia, appear well-positioned to handle the fallout from tighter US rates.

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The FED is set to raise official interest rates over the coming months as the world’s largest economy continues to strengthen. This could cause large capital outflows, sharp currency depreciations (or foreign reserve drains), sharemarket slumps and increased bond yields in emerging markets (EM) as investors reposition their portfolios toward US debt securities.

It appears these events are already in motion. Capital flows into emerging markets have softened to US$24b in the three months to July, down 56% since the March quarter, while spreads between EM sovereign debt and US treasuries—a proxy for risk—have risen steadily over the last four months.

Yet the risk is not equal across EM; those with strong fundamentals appear well-placed to weather the selloff, while others are prone to crisis because of domestic weaknesses. A full-blown crisis akin to the 1997 Asian financial crisis is unlikely, but some EM could suffer significantly from the selloff. To assess, which EM are at risk, we rated each country on four indicators.

  • External vulnerability — does the economy have sufficient buffers to cover its external funding needs and is it a net lender or borrower from abroad?
  • Leverage — how much domestic and external debt does the economy have?
  • Economic stability — what is the growth and inflation outlook? How reliant is the country on commodity exports, given the weakness in global commodity prices?
  • Policy effectiveness — how effective is the government, and how competent the policymakers

The economies most crisis-prone include Ukraine, Russia, Turkey, Argentina, Brazil, South Africa and Indonesia. Ongoing fighting in the Donbas, sanctions on Russia and falling oil prices are putting pressure on both Russian and Ukrainian economies. Turkey has large external deficits, while political uncertainty continues to undermine investor confidence. Indonesia, Brazil, South Africa and Mongolia are heavily dependent on commodity exports and are suffering from low commodity prices, while their governments’ increasingly nationalistic rhetoric is weighing on foreign investment and confidence.

Australia’s direct trade linkages with vulnerable EM, with the exception of Indonesia, are minuscule. Indonesia is our 10th largest export partner and is a major consumer of Australian agricultural products, putting agricultural exporters with exposures to Indonesia at risk. But most of the region’s other EM appear well positioned to handle a potential selloff.

What to make of China’s currency devaluation?

Is China’s recent currency devaluation Beijing’s attempt at greater financial market reform or is it a means to restore export competitiveness and revive a slowing economy? Whatever the reason, the weaker renminbi will reduce Chinese demand for imports, posing risks to economies that rely heavily on China, including Australia.

The motives behind China’s recent 3% currency devaluation remain unclear. Some argue China is stimulating both exports and import-competing industries. But Authorities argue it is part of China’s increasing integration into global financial markets as Beijing is pushing for the renminbi’s inclusion in the IMFs basket of reserve currencies. To maintain control over monetary policy and allow for uninterrupted capital flows, China’s current exchange rate regime will need to become more market-based. To facilitate this, policymakers have introduced new measures to bring the fixed onshore exchange rate— controlled by the central bank — in line with its market-derived twin in Hong Kong (referred to as the offshore rate).

Market-based offshore rates suggest the renminbi has been overvalued against a strengthening US dollar for much of the last year, with futures markets expecting further declines in the coming days and a further 5% depreciation in the next two years. Valuations based on fundamental long run drivers — purchasing power parity, productivity and the real effective exchange rate — suggest the renminbi is overvalued by around 8%.

Whatever the reason for the devaluation, a weaker renminbi will curb Chinese demand for imported goods and services as consumers and businesses switch to cheaper domestic alternatives. Economies with strong trade ties with China, particularly commodity exporters could bear the brunt of this weakness. 

In financial markets, expectations of weaker Chinese import demand on top of the slowing growth trajectory have caused commodity prices to fall further. Some commentators are also expecting negative spill-overs to consumer prices across the globe with markets pricing in a greater risk of deflation through falling long term bond yields.

What does this mean for Australian exporters? Mining revenues will probably suffer from the fall in global commodity prices, while export volumes could ebb as Chinese consumers switch to domestic alternatives. There could also be indirect negative effects on the Australian economy as the ensuing weakness in other major regional trading partners from the Chinese devaluation reduces their demand for Australian goods and services.

Sri Lanka’s political gridlock is clearing

The Sirisena-backed United National Party emerged as the single largest party in the recent parliamentary elections held on 17 August and is expected to form government.

Former Sri Lankan president Mahinda Rajapaksa has conceded defeat in Sri Lanka’s recent parliamentary elections and is set to become part of the opposition.  Prime Minister Wickremesinghe’s United National Front for Good Governance (UNFGG) (contesting as the United National Party (UNP)) secured 106 seats, ahead of Rajapaksa’s United People’s Freedom Alliance (UPFA) with 95 seats.  Wickremesinghe campaigned on a good governance platform, with commitments to economic growth, transparency, ethnic reconciliation and protection of individual freedoms—similar to President Sirisena’s reform agenda.   

But despite being ahead in the polls the UNP have not secured the 113 seats needed to form a majority. This requires the UNP either form a coalition with the Tamil parties—which secured three districts predominantly in the North. Or rely on Sri Lanka’s fluid party alliances and members of the UPFA crossing the floor to give the UNP its necessary majority.

Positive reforms in Sri Lanka will support growth and investment over the longer term, a positive for Australian exporters. Whilst Sri Lanka is a relatively minor market — Australia’s 48th largest goods export market overall — it is a large buyer of dairy and vegetables.

Russia enters recession

The collapse in oil prices and Western sanctions have pushed Russia into its first recession since the global financial crisis. Medium term prospects will remain subdued due to structural and institutional weaknesses, declining productivity growth and an unfavourable demographic profile.

The economy contracted by 4.6% in the second quarter compared with the same period in 2014, after a 2.2% decline in the previous three months (Chart 4). The dual external shocks of lower oil prices and geopolitical tensions have caused a dearth in consumer demand and investment. For the first time in Putin’s 15 years in power, real incomes are falling — leading to a slide in consumer confidence and spending (retail sales fell 9.4% y/y in June). High interest rates and Moscow’s restricted access to international capital markets are also weighing on industry (industrial production fell 4.8% y/y in June).

The Ministry of Economic Development reassures that Russia has reached the ‘lowest point’ of its recession. Indeed large buffers are helping to absorb the shock — after contracting 3.4% in 2015, the IMF expects a mild economic recovery in 2016.

But Russia will continue to be at the mercy of oil markets and sanctions. The IMF believes prolonged sanctions could cost the economy 9% of GDP over the medium term. A ‘lower for longer’ scenario in oil markets is also problematic — oil and gas sales account for about half of government revenues and 70% of exports. For each dollar decline in the oil price, Russia loses about US$2b in potential sales. Moscow requires an oil price of around US$105 to balance its budget.

Medium term growth prospects are subdued. Pre-existing structural and institutional weaknesses, declining productivity and the diminishing labour force, and an over-reliance on natural resources will constrain GDP growth to just 1.5% in the medium term, according to the IMF — well below the rate of global growth and Russia’s share of the world economy.

In particular, economic concentration in a few colossal conglomerates and state-owned companies impedes competition and productivity. SMEs spur innovation and provide diversification, but they contribute just 15% of GDP in Russia compared to an average of 40% in EU countries. Labour productivity growth has slowed from an average of 5.5% p.a. in 2000-08 to 1.9% in 2010-15. And the state’s economic footprint is growing — Russia’s private sector lost 300,000 jobs while the public sector added 1.1m between 2008 and 2012. Institutional weakness is also rife. For instance, Transparency International’s Corruption Perceptions Index ranks Russia 136 out of 175 countries — trailing the likes of Nigeria and Lebanon.

Yet as the economy has slowed and growth potential diminishes, Putin has grown more popular — now armed with an approval rating of 86%. Around 63% of Russians have a very favourable view of their country, up from 29% in 2013. Financial markets haven’t been so kind. Over the last year, the currency has depreciated almost 50% against the USD, making it the worst performer globally, and equity markets are down 40% (Chart 5). Moody’s recently warned the ‘worst of the recession is still ahead’.

Brazil’s investment grade credit rating at risk

Brazil is at serious risk of losing its hard-won investment grade credit rating. Recent downgrades reflect a recession, deteriorating fiscal sustainability and an ongoing political crisis.

Moody’s recently cut its credit rating for Brazil to its lowest investment grade, leaving only Fitch with a ‘junk plus two’ buffer. S&P downgraded Brazil to its lowest investment grade rating in early 2014 and last month cut its outlook to negative. Slippage into junk status would increase borrowing costs and prompt capital outflows. The real is down 24% this year, the worst performance among major emerging market currencies, while external debt spreads of 347 bps (up from 241 bps at the beginning of the year) are trading wide of most peers.

Brazil won investment grade status for the first time in 2008. S&P was then forecasting annual growth of 4.5%. But Brazil is now headed for its worst recession in a quarter-century. According to analysts surveyed by the central bank, GDP will contract 2% in 2015 and 0.2% in 2016 — marking the first two year recession since 1930-31. The IMF recently agreed that ‘Brazil is in a tough spot’.

Industrial output and private consumption have deteriorated sharply. Plummeting confidence reflects stagflation, a tighter monetary and fiscal stance, a worsening job market and erosion of policy credibility. Sentiment has also suffered from political uncertainty associated with corruption investigations. Approval ratings for President Rousseff and her government have declined to less than 10%. Up to 880,000 people took to the streets last week to demand the President’s impeachment, cassation or resignation. These were the third large anti-government protests this year.

The souring political environment continues to undermine the fiscal reform efforts critical to preserving the country's investment grade rating. There remains the possibility that the politically challenging policy correction will face further slippage and the restoration of a firmer growth trajectory will be prolonged. The IMF warns that ‘risks to the outlook are significantly to the downside’ and ‘threaten macro and financial stability’.

The Finance Minister recently conceded that the government would fail to reach its primary surplus target of 2% of GDP this year (considered the minimum level required to stabilise Brazil's heavy public debt burden at 65% of GDP — a level considered by many as already too high for investment grade status).

Although Brazil is Australia's largest trading partner in South America — goods exports were A$1b and services exports A$630m in 2014 — the troubled economy remains a relatively minor market overall (buying 0.4% of total goods exports in 2014). Merchandise exports are dominated by coal and crude petroleum, while 75% of services exports are education-related. Brazil’s severe economic and political challenges are likely to see South America remain on the ‘frontier’ for Australian exporters in the near term.

Can Saudi Arabia survive ‘lower for longer’ oil prices?

Plans by Saudi Arabia to issue debt show the strain that steep falls in oil prices are placing on the public finances of the world’s largest oil exporter and the region’s largest economy. Yet Saudi will remain resilient in the medium term given large fiscal buffers and eventual market rebalancing.

Riyadh has opted to maintain public spending despite lower petrodollar revenues. It requires an oil price of US$105 a barrel to balance its budget. But the price of Brent crude oil has plunged below US$50 from a peak of US$115 last June (Chart 8). The price slide accelerated following OPEC’s decision in November to defend market share against high-cost rivals — by maintaining production levels in the face of weakening demand growth. The International Energy Agency expects the oil glut to persist into 2016. While they expect demand to grow 1.6m b/d this year — the fastest pace in five years — supplies are still growing at ‘breakneck speed’. A supply overhang of 3m barrels a day was recorded in the second quarter of 2015, the most since 1998.

As a result, the IMF projects a fiscal deficit of around 20% of GDP this year. Saudi maintains enormous buffers in the form of foreign exchange reserves. But the government is burning through them fast. From a peak of almost US$750b in mid-2014 they have fallen by US$74b (US$28b in March and April alone) (Chart 9). The government is reportedly planning to raise US$27b in domestic bond markets by the end of the year to slow this decline.

The IMF approves of running down government deposits to finance the deficit and smooth the pace of fiscal adjustment given Saudi’s large reserves and very low public debt. But it warns a sizeable fiscal policy consolidation will be needed over the next few years. In the 1990s, the government also issued development bonds that sent debt to 100% of GDP. These levels eased during the early 2000s when oil prices began their sharp ascent.

The IMF also reassures that the effect of substantially lower revenues on the broader economy has been limited. Real GDP growth is projected to remain at a healthy 3.5% this year, unchanged from 2014, before slowing to 3% over the medium term. Saudi banks’ strong capital, profitability, and liquidity will cushion the slowing in the pace of economic growth, while the recent opening of the Saudi Stock Exchange to qualified foreign investors will help deepen the equity market and broaden the investor base.

Investment cuts by energy companies are eventually expected to rebalance the oil market. Wood Mackenzie estimates that companies have deferred 46 large oil and gas projects with 20b barrels of oil equivalent in reserves — more than Mexico’s entire proven holdings. An estimated 70,000 jobs have been abolished and US$200b of new expenditures have been shelved.

Saudi Arabia is Australia's second largest market in the Middle East. Merchandise exports of A$2.3b in 2014 were dominated by agricultural products and vehicle parts and accessories. Services’ exports are also significant. In particular, more than 10,400 Saudi students were enrolled in Australian colleges and universities in 2014 — the largest contingent from the Middle East region. The long term resilience of Saudi Arabia is a positive for Australia’s exporters.

Risks rise in Papua New Guinea

Slumping global commodity prices and lack of spending restraint is weighing heavily on Papua New Guinea’s fiscal position. This adds to the growing list of concerns over the health of the economy following earlier reports of foreign exchange shortages.

The government’s mid-year budget review released in early August revealed an estimated deficit equivalent to 9.4% of GDP, more than double the 4.4% estimated in November 2014 and the worst on record. Weaker tax revenues from slumping global commodity prices and softer growth—now estimated at 11% in 2015 down from 15.5% beforehand—and the postponed privatisation of public assets are weighing heavily on the budget balance. Even more worrying is the government’s lack of expenditure adjustment, which is exacerbating the deficit.

The fiscal outlook will remain constrained. Global commodity prices are projected to stay weak .But there are tentative signs spending could be pared back with the health department reportedly suffering a A$100m funding cut.

The deteriorating fiscal position could crowd out the private sector as the government saps domestic funds to finance its large deficit. This would add to the dour investment climate as businesses are already complaining about the lack of foreign exchange needed to make payments to overseas suppliers.

Cassandra Winzenried, Senior Economist

Fred Gibson, Economist

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Photo credit: © Yuriko Nakao / REUTERS / PICTURE MEDIA