World Risk Developments July 2015

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Economic reverberations of China’s equity sell-off contained

China’s equity markets have suffered their sharpest downturn in over two decades, erasing roughly US$4 trillion from their listed value — double the value of India’s GDP. But the risk of a systemic financial crisis is contained.

View a summary of this month's edition.

Fuelled by leverage and expectations of aggressive monetary easing, China’s benchmark Shanghai Composite Index reached a seven-year high on 12 June to be up 150% for the year. This made it the best performing bourse in the world, albeit one increasingly at odds with the slowing real economy. However, it then lost more than a third of its value over the next four weeks.

A raft of unconventional and increasingly drastic policy measures have since restored investor confidence and stabilised markets (Chart 1). These include interest rate cuts and liquidity support from the Central Bank, more permissive rules on margin trading, direct stock purchases, restrictions on market activity, and a suspension of initial public offerings.

Concerns linger that the rebound won’t last if government support is withdrawn. But the risk that the equity sell-off could reverberate through the wider economy, by weakening the financial system and undermining consumer activity, appears limited for three reasons.

  1. Limited wealth effect. Household exposure to equity markets is low — less than 15% of their financial wealth. Only 8% of the total population has a stock market trading account compared to an estimated 29% of Australian households. Besides, equity values remain around double what they were last year, leaving long term investors well in the black. Finally, exposure is concentrated in wealthy households that are less likely to adjust their spending abruptly. Together, what these factors suggest is a limited impact on consumption. Consider Chart 2, showing that retail sales have been soft and consumer confidence worsening even as share prices were soaring over the last year. Just as equity prices did little to boost consumption over this period, we doubt that the sell-off will do much to discourage consumption now.
  2. Resilient banks. China’s banking behemoths have a balance sheet close to RMB200t — exposure to lower equity valuations is therefore a small fraction of total banking assets. Moreover, equity financing plays a small role — accounting for just 5% of private sector fundraising.
  3. Macroeconomic policy flexibility. The authorities have ample firepower to avoid systemic crisis. Additional easing to sustain growth momentum is expected to include monetary and fiscal stimulus and administrative measures.

But the hasty series of market interventions has raised investor concerns over Beijing's commitment to reform — particularly financial market liberalisation and capital account opening. Its goal of achieving IMF reserve currency status is likely to strengthen its resolve. But the dramatic policy response may also sap investor confidence in the broader ability of government to rebalance China's growth composition and move to a market based economy.

Volatility in China’s equity market has weighed on the prices of Australia’s key mining exports and the Australian dollar — the iron ore price fell to a low of US$49 a tonne and the AUD bottomed at US73c following the sell-off. While lower commodity prices over the last month appear in part sentiment-driven, weak fundamentals will continue to weigh on commodity prices and the exchange rate. Sustaining a more competitive currency will aid Australia’s transition to a more diversified export profile.

Greece limps forward

Greece has managed to strike a deal with its creditors, but without debt forgiveness the long run outlook remains dire.

The economic crisis has simmered down since the government accepted the large majority of demands from its European creditors in exchange for bailout funds. Though voters rejected the terms of the bailout offered by those creditors in a referendum earlier this month, the government clearly saw little choice but to accept them.

Why? Because as PM Tsipras put it, accepting was the ‘least bad’ option. It keeps alive the ECB’s liquidity support for Greek banks and also the hope of more funds to meet public debt repayments. By contrast, rejection would have triggered a full-blown banking crisis and sovereign debt default. In the ensuing chaos, the government would have been forced to issue its own currency and thereby potentially leave the eurozone.

What next? The bailout funds will buy Greece time, but the large public debt burden equivalent to 177% of GDP and harsh austerity that comes with the funds will remain obstacles to long run solvency. The Greeks have reduced their stock of debt by 10% over the last four years, but in doing so the economy has shrunk close to 15%. This implies the debt position as a share of the total economy has actually deteriorated and the harsh austerity has been self-defeating. Indeed the large debt burden will remove the incentives for structural reforms as gains from a stronger economy would go to external creditors and not the Greek public.

The IMF has warned that ‘Greece’s public debt has become highly unsustainable ... and can now only be made sustainable through debt relief measures that go far beyond what Europe has been willing to consider so far’. All that Europe seems prepared to consider is another ‘extend and pretend package’ which stretches out, but doesn’t write down, the outstanding debt.

A similar unpreparedness to provide prompt debt relief marked the Latin American debt crisis of the 1980s. Many Latin American countries found themselves at the start of that decade with unrepayable debts. On the creditor side, many US banks found themselves with Latin American portfolios threatening their solvency. So the US Treasury and IMF went to work to organise bailouts of the countries. These enabled the debtors to repay much of their debt to the banks. With the banks now off the hook and the debt semi-socialised, the Fund and remaining private creditors set about collecting their money. But that proved impossible, so they stretched out and rolled over the repayments, with no present value writedown. This game was played till the end of the 1980s when the reality finally dawned that the debt would never be repaid, and the so-called Brady Plan came into being. This allowed debt-for-bond swaps providing forgiveness of 30-50%. Only when the debt overhang was removed did Latin America’s ‘lost decade’ of growth come to an end. Perhaps this experience is illustrative of what will happen to Greece.

What does the crisis mean for Australia? Our direct trade links with Greece are limited as it is only our 105th goods export market, buying less than 0.1% of our total goods exports or A$13m. The commotion did weigh on Europe’s financial markets, but contagion to Australian markets has been limited. However, Greece’s eurozone membership remains in question and a ‘Grexit’ could weigh heavily on global financial markets, placing constraints on Australian exporters.

Vietnam’s prospects improve amid foreign investment push

The government is offering concessions to foreign investors on top of broader efforts to boost lacklustre economic growth via structural reforms and international money and trade deals.

The government has announced long-awaited legislation that will scrap a 49% cap on foreign ownership in some industries. While some leading industries will remain exempt — such as banking which will maintain ownership limits at 30% — Vietnam’s foreign investment push coincides with efforts to revive a sluggish privatisation program, conclude trade deals with the US and EU, align commercial laws with international norms, and upgrade its status from ‘frontier’ to ‘emerging’ in the influential MSCI index.

Reforms should spur economic prospects and export opportunities. Vietnam grew by 6% in 2014 — the strongest pace since 2011. In particular, industry expanded by 7.1%, against 5.4% in 2013, benefitting from FDI that boosted manufacturing. Official data show that new FDI commitments rose to US$15.6b in 2014, while an extra US$4.6b was committed to existing foreign-funded projects. Concerns remain about the inflated property market, bad debts in the banking system and lingering financial problems at state-owned enterprises. But pro-investor reforms, a comparatively good business environment (Chart 4) and economic recovery in advanced economies — particularly the US, Vietnam’s most important export market — suggest faster economic expansion in Australia’s 13th largest international market.

Nuclear deal yields dividends for Iran’s economy and global oil consumers

Iran and P5+1 world powers have reached a historic accord to curb Iran's nuclear program allowing for the eventual lifting of sanctions. Providing the deal survives opposition in Tehran and Washington, it will end a 13-year nuclear stand-off and reconnect the US$400b Iranian economy to the world.

The deal imposes tight restrictions on Iran’s uranium enrichment program and a rigorous international inspections regime. In return, the removal of sanctions would breathe life into Iran’s quarantined oil and financial sectors. This could in turn spur a sharp economic recovery and sizeable foreign capital inflows, and restore access to more than US$100b in frozen assets. The Institute for International Finance estimates that growth could double as a result — from about 3% in FY2016 to 6% in FY2017.

A sanction-free Iran will offer significant long term business opportunities. The country is characterised by a large middle class consumer base, a highly skilled labour force, strong domestic industrial base and relatively diversified economy. Consumer goods, pharmaceuticals, financial services, telecoms, and transport all show potential. Yet investors will probably move cautiously — watching the longevity of the nuclear deal and the commitment of authorities to improving business conditions. Iran’s regulatory and bureaucratic environment is poor — ranking 130th in the World Bank’s ease of doing business gauge — behind regional peers Saudi Arabia at 49 and the UAE at 22 (Chart 5). That, plus sanctions, has resulted in Iran attracting only US$2.1b in FDI last year, compared to Saudi Arabia’s US$8b.

Dividends of a nuclear deal will also flow to global oil consumers. The International Energy Agency warned this month that the global oil market is ‘massively oversupplied’ — the OPEC price war continues, US stocks and production are high (as shale producers increase efficiency), and demand continues to stagnate. Increased Iranian oil exports are not expected to flow until early 2016 — dependent on the International Atomic Energy Agency confirming Iran has complied with its side of the bargain. But the spectre of a supply increase from a major producer will keep downward pressure on oil prices over the medium term. Forecasters expect Brent crude prices will average US$60/b in 2015 and US$67/b in 2016. A sustained period of lower oil prices will pose challenges for Australian LNG projects.

Indonesia’s economy is losing steam

The Indonesian government’s increasingly nationalist stance is posing risks to foreign investment and growth.

Indonesia’s growth slipped to its slowest rate in six years after the economy expanded 4.7% y/y in the opening quarter of 2015. Lower commodity prices and a lack of progress on growth-enhancing reforms are behind the slowdown. This has prompted the World Bank to revise down its 2015 growth forecast to 4.7% from 5.2%.

China’s slowing economy and its shift away from investment led-growth is weighing heavily on global commodity prices and Indonesia’s export earnings. But the government’s growing nationalist stance is arguably a greater risk to the outlook. The Widodo-led government is publicly pro‑foreign investment and is committed to diversifying the economy away from mining toward manufacturing and services. But the ‘negative investment list’ — a list of sectors in which foreign investment is off-limits — has grown since Widodo assumed office, which has not gone down well with foreign investors. Total foreign investment fell by 4% y/y in the March quarter of 2015, following an 8% decline a quarter earlier. Much of the weakness has been felt in the manufacturing sector and undermines the government’s push to diversify the economy.

There is also increasing uncertainty over the government’s policy outlook after it banned the sale of beer by small retailers. The law itself won’t hurt foreign investment, but it was the lack of consultation and ad hoc nature of the legislation that has many investors worried.

Improving Bangladesh bodes well for Australian companies

Rising household incomes and inadequate energy infrastructure present opportunities for Australian companies.

The World Bank said Bangladesh’s per capita income had risen to US$1080 in its annual review. This means it has officially been upgraded to lower-middle income economy status.

Ranked as a low income country previously, robust growth —despite persistent political upheavals — has lifted incomes. Key to Bangladesh’s success has been the textiles industry which is both a major source of foreign direct investment and export earnings, contributing 15% to GDP. Both the US and eurozone are amongst the largest customers for Bangladesh’s garments.

The outlook is bright. The IMF expects growth will average 6.8% p.a over the medium term supported by abundant cheap labour and the growing textiles sector. Bangladesh has also resolved its border disputes with India and is party to the South Asian free trade agreement, where all members have agreed to drop customs duties by 2016. Stronger trading links with India’s fast-growing economy adds further upside to the outlook.

What does this mean for Australia? Bangladesh is currently our 39th largest trading partner, but is the second largest buyer of vegetables behind India. Bangladesh also buys significant amounts of cotton and dairy products. Strong population growth and rising incomes present opportunities for Australian agricultural and consumer good exporters. Bangladesh also faces chronic power shortages as energy infrastructure remains inadequate, while coal and gas reserves are yet to be exploited. This could present opportunities for Australian energy infrastructure companies as well as energy producers.

Cassandra Winzenried, Senior Economist
cwinzenried@exportfinance.gov.au

Fred Gibson, Economist
fgibson@exportfinance.gov.au

The views expressed in World Risk Developments are Export Finance Australia’s. They do not represent the views of the Australian Government. The information in this report is published for general information only and does not comprise advice or a recommendation of any kind.  While Export Finance Australia endeavours to ensure this information is accurate and current at the time of publication, Export Finance Australia makes no representation or warranty as to its reliability, accuracy or completeness.  To the maximum extent permitted by law, Export Finance Australia will not be liable to you or any other person for any loss or damage suffered or incurred by any person arising from any act, or failure to act, on the basis of any information or opinions contained in this report.  

Photo credit: © Aly Song / REUTERS / PICTURE MEDIA