World Risk Developments June 2015


Turkish election ends era of political stability

The incumbent Justice and Development Party (AKP) won this month’s general election but lost its majority in parliament. This marks a major shift in Turkish politics — the AKP has won successive landslide victories since coming to power in 2002. The result has increased near term political and economic uncertainty, but improves longer term prospects by making the political system more contestable.

View a summary of this month's edition.

The election outcome delivered lower support for AKP (down almost 10 percentage points since the 2011 election) amid a weakening economy, policy drift and disillusionment with President Erdogan’s plans to concentrate power. But the most significant development was the passing by the pro-Kurdish People's Democratic Party of the 10% threshold to enter parliament for the first time. (1)

The AKP now has two options — form minority government or a coalition. A coalition is more likely. The former would require a parliamentary vote of confidence and heavily constrain the AKP if and when the opposition unified. Both arrangements would be fragile, making an early election a strong possibility. Parliament has 45 days to establish a cabinet, after which Erdogan can call for a new election.

Financial markets responded negatively to the election result — the already weak lira depreciated 4.5% against the USD the next trading day. Post election policy uncertainty will depress already subdued investment and domestic activity. This raises Turkey’s economic vulnerability given the country’s sizable current account deficit (almost 6% of GDP, Chart 1), largely financed through fragile short term capital inflows that are dependent on international investor sentiment. Further risk arises from looming US Fed interest rate hikes that will make securing foreign inflows more expensive.

But while the election result has increased uncertainty it has also helped allay concerns about Turkey’s democracy. Despite isolated episodes of violence, voter turnout was high and fears of vote rigging unfounded. The weakened position of the AKP will probably strengthen the hand of the central bank in setting independent monetary policy. The central bank is now expected to respond to the lira's depreciation (Chart 2) and the concomitant rise in inflation by raising interest rates. A minority or coalition government could also reduce regulatory burdens and lower the risks of judicial interference and threats of expropriation and contract frustration. Importantly, the result stymies President Erdogan’s controversial plans to alter the constitution to concentrate executive power and should make the political system more contestable. This bodes well for longer term prospects to grow Australia’s 35th largest export market.

India’s pro-business reforms steady but slow

Big government and red tape are frustrating required reforms to put India in the top 50 business-friendly countries.

Prime Minister Modi aspires to place India at the centre of global manufacturing and rank among the top 50 countries in the World Bank’s Doing Business gauge by 2017. But India’s ranking in this index has steadily deteriorated since 2006 to 142nd — one place above the West Bank and Gaza, and considerably behind BRICs peers. (2)

Modi's ambitious market-oriented reform agenda aims to improve infrastructure and labour flexibility while reducing red tape and the role of the state in business. To this end, the central government has streamlined the approvals process through an 'E-biz' platform, provided for single-step incorporation of companies, initiated reforms in company and bankruptcy law, and reduced documentation for exports and imports. A process to rank all state governments for ease of doing business has also began — intended to increase competition among states and attract investment. This is similar to  Indonesia, which has attracted an annual survey of its provincial business micro‑climates.

But Modi is dependent on the judiciary and state governments to honour his pledges. This has resulted in uneven reforms across states and sectors dependent on the degree of cooperation from counterparties. For instance, India ranks in the bottom 5% of countries for obtaining construction permits and enforcing contracts (Chart 3). The World Bank estimates that 25 different procedures and an average of 186 days are required to obtain an initial permit to construct. The process involves state and municipal authorities constitutionally independent of the central government. Several states have committed themselves to improving business conditions — for instance, Maharashtra has reportedly reduced the time to gain a permit from 162 to 60 days. Yet other states do not share the same urgency. Modi’s government is attempting to reduce state-level control in key areas like natural resources and taxation, but these reforms are in early stages.

Contract enforcement involves institutions under serious strain — over 30 million cases remain in backlog in Indian courts. The World Bank estimates it takes an average of 46 different procedures and four years to enforce a contract.

India’s low starting point and conflicting policymakers will make achieving a ranking in the World Bank’s Top 50 a challenging task likely to be deferred beyond Modi’s two year target.

Cheap money fuels stock markets despite weak fundamentals

A liquidity-driven surge in Chinese stocks indicates that investors are increasingly driven by the monetary policy actions of central banks, rather than stronger economic fundamentals and faster corporate earnings growth. This decoupling has raised fears of increased volatility and a policy-induced asset bubble that could threaten financial stability and a ‘soft landing’ in our largest export market.

The Shanghai and Shenzhen stock indices have more than doubled over the past 12 months (Chart 4). The rally has been characterised by the opening of millions of new stock trading accounts (Chart 5) which has fuelled a spike in turnover volumes and margin debt. As a result, the combined market capitalisation of Chinese equities has jumped by over US$6.5t to US$10t (Chart 5). This additional value is equivalent to more than three times the value of the German stock market or India’s annual GDP. The Shanghai Composite — China’s benchmark stock market index — now trades at 26 times current earnings, up from just 10 times a year ago. Gauging price gaps between stocks dual-listed in Hong Kong and China indicates that mainland listings are typically over 30% more expensive than their offshore counterparts.

But as stock markets surge and equity funds enjoy record inflows, concerns are mounting about the slowing economy and vulnerabilities in the shadow banking system and property market. On 28 May the Shanghai Composite fell sharply, sparking fears of a major correction. Yet it rebounded strongly on 1 June following the publication of mixed data about the health of China’s manufacturing sector. This suggests that weak economic data are prompting the purchase of stocks — because they increase expectations of further monetary and fiscal stimulus to spur growth. Paradoxically, bad news is deemed good news. But this decoupling of equity prices from economic fundamentals threatens the rally's sustainability and has raised concerns of an asset bubble.

In addition to China-specific risks, equity market valuations are also threatened by the increasing likelihood of a Greek debt default and expected rises in US interest rates. The US Federal Reserve is expected to start hiking rates later this year.

Infrastructure opportunities in Africa

Africa’s infrastructure needs presents opportunities for Australian exporters and investors.

Deficient infrastructure is creating bottlenecks in Africa’s largest cities and constraining growth. But a recently released report from PwC suggests Sub-Saharan Africa’s infrastructure spending will grow 10% annually over the next decade to reach US$180b per annum — with a heavy focus on transport and energy. 

The PwC report also highlights skill shortages and insufficient funds as major obstacles to infrastructure projects. These shortages create opportunities for Australian companies. Australian investment in Africa was worth A$5b in 2014 (0.3% of Australia’s total overseas portfolio), concentrated in South Africa. This has been little changed over the last decade. Service exports to the region meanwhile were worth A$1b in 2013-2014. Australian firms that provide mining engineering and technology services, infrastructure solutions and consultancy services are particularly well placed to fill the skill shortages. There may also be opportunities for Australian SMEs in procurement stages of the projects.

Doing business in Africa isn’t without risks, however. Political risks from corruption, expropriation and unstable governance are often major deterrents. Indeed most Sub-Saharan African countries are ranked in the lowest quartile in both the World Bank’s ease of doing business and governance measures.

Russia could face tighter sanctions

Global leaders are threatening tougher sanctions on Russia as fighting in the Donbass escalates.

Fighting between Russian-backed separatists and Ukrainian troops continues making February’s ceasefire agreement look increasingly fragile. Global leaders have expressed their concern and threatened further sanctions against Russia in a joint communiqué released after the recent G7 meeting.

Russia is suffering from the current round of sanctions and lacklustre oil prices. The IMF expects the economy to contract 4% in 2015 and 1% in 2016. But tighter sanctions, particularly if they include expulsion from international payment systems, would further ostracise Russia from the international community. Under this scenario, Russia would be cut off from international financiers and trade flows would dry up, causing the economy to contract further.

How bad could it get in Russia? Iran offers some insight as it has been locked out of international payment systems since March 2012 following disputes over its nuclear weapons program. Its economy has contracted 9% post 2012 as sanctions weigh heavily on oil exports and the ability to access offshore revenues. Foreign banks have also been forbidden to provide finance to Iranian business, weighing heavily on the private sector. If Russia were to suffer a similar fate, the economy would contract 6.5% in 2015 and 2% in 2016, with GDP unlikely to recover to 2014 levels over the next five years. 

South Korea responds to MERS threat

The Bank of Korea (BoK) slashed policy rates to a record low 1.5% in a pre-emptive bid to cushion the economy from an outbreak of Middle East Respiratory Syndrome (MERS). But the rate cut was also prompted by broader long term economic headwinds in Australia’s third largest export market.

The MERS panic is expected to take a heavy toll on tourism and consumer confidence until the disease is convincingly contained. Some 54,000 foreign tourists have cancelled trips to South Korea since the outbreak was confirmed on 20 May, and department store sales fell 17% in the first week of June. Other signs of public alarm have been school closures and public event cancellations. Economists estimate MERS could cut the country’s growth by 0.1 percentage point this year if visitor numbers fall as much as they did during the 2003 SARS crisis. That outbreak infected over 8000 people and caused estimated losses to the world economy of up to US$30b.

But the slowdown began long before MERS surfaced — the economy grew 2.4% in the first three months of 2015, the slowest rate in two years. Exports fell 11% yoy in May, their largest fall for six years, as the won hit a seven year high against the yen and undermined manufacturers’ export competitiveness.

While lower interest rates will boost confidence they won’t be a panacea for sluggish exports. Concerns for financial stability amid excess household debt will make the BoK cautious about further easing. Fiscal stimulus may therefore be added to the arsenal to counter MERS and achieve the IMF’s reduced growth forecast of 3.1% this year.

Thailand’s military-led government one year on ...

Political uncertainty is weighing on foreign investment and growth, posing risks to Australian companies with exposures to ASEAN’s second largest economy.

Political risk remains elevated one year after the army staged its coup. The military-led government continues to push out Thailand’s return to democracy after it rescheduled elections to August 2016 at the earliest. Elections were initially due in October 2015.

But uncertainties over the return to democracy and the contents of the new constitution are weighing on foreign investment (Chart 7) and growth. Foreign investment has been on a downward trend after the political upheavals began in late 2013. The economy expanded a mere 0.9% in 2014, but is forecast to eke out 4% this year. The unsettled political landscape and softer global growth pose risks to the export-oriented economy. 

The slowing Thai economy and political uncertainty are weighing on Australian exports (Chart 8). Total export receipts from Thailand (excluding crude oil exports) fell 10% in 2014 as weak demand and slumping commodity prices dragged on exporter incomes. Exports in the first four months of the year continue to trend lower, suggesting further weakness in the months ahead. Australian direct investment is also suffering, falling 20% to A$553m over 2014.

Cassandra Winzenried, Senior Economist

Fred Gibson, Economist

(1) Turkey’s voting system requires a party to win 10% of the national vote before its elected representatives can enter parliament. This means that if a party wins 40 seats but receives only 9.55% of the national vote, as the True Path party did in the 2002 elections, it forfeits those 40 seats, which are then reallocated to larger parties.

(2) Brazil ranks 120th, Russia 62nd, China 90th and South Africa 43rd.

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Photo credit: © Murad Sezer / REUTERS / PICTURE MEDIA