World Risk Developments March 2015


China — pursuing economic quality over quantity

Premier Li Keqiang announced a lower GDP growth target of around 7% at the National People’s Congress this month, prompted by economic underperformance and intensifying headwinds. While policymakers continue to cushion the slowdown, Li unveiled a longer term policy plan to move China away from expansion at all costs. Curbing corruption and pollution and rebalancing the economy towards consumption and private sector innovation is at the core of reform.

Almost two thirds of China’s provinces missed their growth targets last year, with underperformance concentrated in heavy industrial regions (Chart 1). For instance, GDP growth in Heibei — which has a steel production capacity larger than the combined output of Japan and South Korea — was 4% below target. All 31 provinces cut their growth targets for 2015, bar Tibet (which set the same target) and Shanghai (which abandoned growth targets altogether).

China’s authorities acknowledge that downward pressure on China’s economy is building. Indeed economic data for January and February was disappointing. Deep-seated problems in development are sufacing, including a stalling property market, high debt levels, excess capacity in industry, and disinflation.

Authorities continue to cushion the economic slowdown with monetary and fiscal stimulus. China’s central bank cut interest rates this month for the second time in three months. Beijing plans to increase government spending by 11% this year, raising the budget deficit to 2.3% of GDP (compared with 2.1% last year and 2.8% in 2009 when Beijing splurged on stimulus to counter the GFC).

But reform priorities will see China rebuff expansion at all costs. Li heralded a ‘new normal’ of slower growth and vowed to fight pollution and corruption, control China’s debt surge and put the economy on a more sustainable footing after three decades of rapid growth.

In particular, efforts to rebalance the economy will focus on boosting consumption while relieving an overdependence on exports and inefficient investment. To this end, the target for fixed asset investment growth was lowered to 15% (from 17.5% in 2014); while the targeted level of urban job creation was maintained at 10 million. But the targeted level of broad money supply was set two percentage points higher than the nominal GDP growth target — implying credit-fuelled growth will continue in the near term. Reforms also aim to reduce overcapacity in polluting heavy industries and move factories up the global value chain. A Made in China 2025 strategy seeks greener innovation-driven development that will ‘upgrade China from a manufacturer of quantity to one of quality’.

This new economic growth model is likely to keep pressure on Australia’s mining exports. Indeed, China’s imports of major commodities have continued their decline this year. While fuelled primarily by lower commodity prices, a slowdown in opportunistic buying has also weighed on China’s import volumes. For instance, iron ore imports registered a 45% y/y fall in value terms in January-February, but also fell 1% in volume terms.

But Li also foreshadowed measures to increase efficiencies and strengthen market forces. He promised a greater role for private business and a halving of the number of industries in which foreign investment is restricted. Along with new consumer demand, these liberalising reforms promise new opportunities for Australian exporters.

Euro Area — QE provides relief; but Greece a persistent headache

The stronger European outlook will provide upside to Australian exporters. But ongoing Greek tensions and Europe’s tight fiscal policy still pose considerable risks.

The ECB officially launched its bond buying program in early March. Policymakers are confident this will lift growth to 1.5% in 2015 and 1.9% in 2016, up from prior projections of 1% and 1.5% respectively. Inflation is expected to rise toward the ECB’s official 2% target by 2017, allaying fears of a deflation trap. The stronger outlook has been driven by lower oil prices and the sharp depreciation in the euro which will benefit Europe’s net exports. Indeed, the euro has depreciated 6% against the AUD since January, and is falling toward parity against the greenback.

Stronger growth will lift European demand not only for Australian exports, but those from China and the US, which will have positive spillovers on Australian companies involved in global supply chains. QE has also calmed financial markets (Chart 2), a positive for Australian business confidence.

But ongoing gamesmanship between Greece’s newly elected Syriza party and the Troika present headwinds. Greece is proposing to scale back its mandated austerity measures to revive growth; but the Troika are concerned this will stunt structural reforms necessary to get Greece back on track. Last month the Greek government secured a 4-month extension to its current loan arrangement. But policy reforms still need to be agreed and implemented before additional financial support will be disbursed. In a worst case scenario, the Troika could withhold much needed funding, forcing Greece out of the currency union and raising the odds of a euro area break up. But this remains a tail risk — both negotiating parties have a strong interest in avoiding ‘Grexit’.

Posing further risks to growth are restrictive fiscal policies in highly indebted euro zone members,  likely to push against monetary easing. Recent experience in the US suggests that large scale QE was most effective when accompanied by expansionary government spending.

Russia — Uncertainty surrounds Minsk II ceasefire and Russia’s economy

The Minsk II ceasefire provides for a temporary truce rather than a long term viable stop to the conflict in Eastern Ukraine. Lower oil prices and Western sanctions are causing Russia’s economy to contract and raising the risk of a banking crisis this year. Ongoing geopolitical tensions mean business uncertainty and contagion risks will endure.

A ‘Minsk II’ ceasefire brokered last month followed marathon negotiations between leaders of Russia, Ukraine, Germany, and France. But expectations for the truce’s longevity are low. According to the French President it provides just ‘a glimmer of hope’ for settling the conflict. Heavy fighting ensued right before the deadline, and continued sporadic violence threatens it now. Ukraine's military reports over 60 soldiers have been killed since the ceasefire came into effect on 15 February, while Russia continues large-scale military exercises in Crimea.

The uneasy ceasefire has reduced the risk of fresh sanctions on Russia — despite increased non-lethal military aid from the US and calls for the creation of an EU army. Still, existing sanctions and lower oil prices are exacting a high economic toll. The IMF expects Russia’s GDP to contract by 3% this year. Investment is expected to contract at a double-digit rate, given a lack of external financing and high domestic borrowing costs (interest rates are currently set at 14%). Consumption is expected to shrink as inflation (16.7% in February) and government spending cuts erode incomes. Moody’s cut Russian sovereign debt to ‘junk’ last month following a similar decision by S&P in January.

In particular, Russia's banking sector faces serious risks in 2015. The deteriorating economy and high interest rates will increase credit losses, thereby reducing bank profitability and capitalisation. Already 242 out of 834 Russian banks are reporting losses . The risk of panic-driven deposit outflows is high amid soft confidence in the Russian economy and currency. Capital outflows reached nearly US$150b last year.

Banks are increasingly reliant on ongoing and extraordinary government support. In February, Tavricheskii Bank and FundServisBank were put into temporary administration. Last year VTB and Gazprombank received RUB100b and RUB40b respectively in support, while a run on private sector Trust Bank forced a bailout constituting the second-largest in post-communist Russia. A high reliance on central bank liquidity amid low external financing will continue.

Australian exports to Russia (concentrated in agriculture) have fallen significantly since retaliatory sanctions were imposed in last August. Continuing geopolitical tensions mean sanctions are unlikely to be reversed any time soon while the deteriorating economy will reduce market opportunities. But direct trade effects are dwarfed by the broader effects on confidence and contagion risk.

Nigeria — lower oil prices and security woes threaten Africa’s ‘next frontier’

Nigeria is tipped to become a global economic powerhouse. Thought to be in an economic sweet spot, competitive advantages include a large consumer market and commodity endowment, a strategic geographic location and a young and entrepreneurial population. Yet the country’s vast market potential is being threatened by increasing political and security risks as well as falling oil prices — which are playing havoc with public finances and the currency.

Nigeria is a large and diverse economy that has achieved a decade of solid growth. UN estimates see Nigeria’s population rising from 180 million to 440 million by 2050, making it the world’s third most populous nation behind India and China. An official recalculation of GDP in 2014 revealed Nigeria has already leapfrogged South Africa to become the continent’s largest economy. And PwC expects it will be the fastest growing major economy from now to 2050 — propelling it up global rankings from 20th currently to 9th in 2050 (GDP in PPP terms). Investors are taking note — foreign investment has long focused on the oil sector, but portfolios are now diversifying to power, agriculture and mining.

But frustrating Nigeria’s boom are intensifying economic and security tensions — the IMF expects growth to fall below 5% in 2015. Nigeria is the world’s sixth largest net oil exporter — the proceeds of which provide about 70% of total government revenue. Sharp oil price declines in the back end of 2014 have led to dramatic currency depreciation raising inflation pressures, and reduced already slim fiscal and external buffers. Despite early signs of supply cutbacks, global oil production currently outpaces consumption by around 1.5m b/d — indicating continued pressure in the near term.

Political risks have also ratcheted up after elections scheduled for February were delayed (now due 28 March) owing to security concerns. The extremist group Boko Haram has continued deadly attacks in the country’s north-east — where it aims to carve out an Islamic state the size of Belgium — despite recent advances of the Nigerian military and foreign troops. Aside from renewed security issues, Nigeria also lags its peers in critical infrastructure and has high rates of poverty, endemic corruption and income inequality. Nigerians typically die 8 years earlier than their poorer neighbours in Ghana.

Against these odds Nigeria has became Australia’s 11th largest market for wheat exports. Nigeria purchased $187m worth (3% of total exports) last year, ranking it behind traditional MENA buyers Yemen and Sudan, but in front of New Zealand and Thailand. While Australia’s other exports to Nigeria are nominal (Chart 3), market potential is enormous. A rapidly expanding consumer class will support the agriculture, retail and wholesale trade sectors along with infrastructure development.

Saudi Arabia — smooth transition unlikely to alter oil outlook

Saudi Arabia’s new king will uphold the polices of his predecessor. This includes maintaining the kingdom’s current level of oil exports in the face of rising non-OPEC production — a dominant driver of current low global oil prices.

The transition of power to King Salman bin Abd-al-Aziz after the passing of King Abdullah in late January has been smooth. Policies under the new king are likely to remain unchanged from his predecessor, particularly on oil production. Saudi Arabia is often touted as the globe’s swing oil producer, cutting back on exports to buoy global oil prices when conditions are unfavourable. But the world’s top oil exporter has not cut output since oil prices began to slump in July last year, fearing a loss of market share. This has weighed further on global oil prices — with both benefits and costs to the Australian economy.

Saudi Arabia’s low debt profile, large chest of reserves and low oil production costs (Chart 4) will allow it to ride out the low price environment, while high cost producers shut down. This is already happening in the US where high-cost shale producers are starting to scale back production. This has supported a mini-bounce in global oil prices since February, although supply growth is not expected to moderate significantly before late 2015.

The kingdom’s vast reserves have allowed it to maintain public spending despite falling oil prices; yet the growing number of unemployed youths will present challenges over coming years. Outside of oil, the new king will remain focused on domestic security. 

Cassandra Winzenried, Senior Economist

Fred Gibson, Economist

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