The Fed has resisted the urge to raise interest rates at its September meeting as vulnerabilities in emerging economies, including China, weigh on the global outlook. Forecasters were expecting a rate rise, the first since 2006, driven by underlying strength in the domestic economy as reflected in improving labour market conditions. But it erred on the side of caution as the deteriorating global growth outlook and strengthening USD poses risks to exporters and the rest of the economy. Markets now expect the Fed to raise rates in 2016—although its statement following September’s decision has not made the interest rate outlook any clearer.
The ongoing uncertainty over US interest rates has raised volatility in financial markets and a selloff of riskier emerging market assets, causing most EM currencies to depreciate (Chart 1). This poses risks to EM companies that borrowed in USD to capitalise on record low US interest rates over much of the last six years. Growing investor risk aversion and higher US interest rates over the coming years will raise the interest rate EM companies must offer to roll over their debts.
EM foreign-denominated corporate debt has risen to US$1.1t in 2014, up from US$400b in 2007. Companies in the BRICS have been particularly aggressive at tapping foreign capital markets with US$760b of outstanding foreign currency denominated corporate bonds. Yet whilst Chinese companies have issued lots of foreign-currency debt, it is only equivalent to 9% of China’s large war chest of foreign reserves. A large holding of reserves gives policymakers scope to intervene and cover external corporate sector or related banking sector debts if there are large defaults, thus limiting systemic risk to the rest of the economy. Commodity producers, Mongolia, South Africa, Brazil and Russia do not have the same level of cover as falling commodity prices have reduced export earnings and foreign reserves. Hard currency export revenues are often used to service foreign-currency debts, providing a natural hedge to currency movements. Not surprisingly Russia, Mongolia, South Africa and Brazil have all been identified as vulnerable to capital flight (Table 1).
Closer to home, companies in most regional trading partners, particularly China, appear less vulnerable to a selloff. But firms in Indonesia and Malaysia could come under pressure should commodity prices and their currencies fall further.
India — remaining resilient to external shocks
India remains a bright spot of comparative resilience amid increased emerging market vulnerability. But strengthening economic potential may be thwarted by a failure to deliver on the reform agenda.
India’s official GDP growth rate exceeded China’s over the first half of 2015, and has powered ahead of other increasingly troubled BRICS peers (Chart 2). As in China, India’s GDP figures probably overstate economic performance. But whereas China looks set to slow, India could well accelerate. That at least is what the IMF’s latest set of economic forecasts thinks. These see China’s growth decelerating to 6.8% in 2015 while India speeds up to 7.3%.
India seems to have more resilience to the setbacks now besetting other emerging economies — basically weakness in China, oil and commodity price falls, and financial volatility. It is relatively insulated from decelerating Chinese growth given its limited integration into Chinese manufacturing supply chains. While the oil price slump is creating economic hardship in Russia, India imports 70-80% of the oil it consumes and therefore benefits greatly from lower oil prices. A cheaper energy bill has helped narrow the current account deficit to 0.2% of GDP. Downward commodity prices have also dramatically reduced inflation and allowed for accommodative monetary policies that stimulate the economy. Finally, India is relatively well insulated against increased financial market volatility given a lesser reliance on foreigners to fund ever increasing current account shortfalls.
India is tipped to become the world’s most populous country by 2028 and possesses favourable internal demographics (the median age is 27). But at current prices and exchange rates, the economy is worth just US$2t compared to China’s US$11t. In addition to strong population growth, rapid urbanisation will be required to boost India’s contribution to the global economy. This in turn will require Prime Minister Narendra Modi’s government to deliver on an ambitious reform agenda. But while faster project approvals and higher public investment in infrastructure has eventuated, a controversial land reform bill has recently stalled and a plan to overhaul labour laws is yet to be released. Legislation to replace a myriad of indirect state taxes with a business-friendly nationwide goods and services tax is also stalled in parliament. Modi’s reformist agenda has been frustrated by his government’s minority in the upper chamber and dependence on the judiciary and state governments to honour pledges.
Despite being our 7th largest export market, India is often cited as a source of untapped potential for Australian exporters. Strengthening economic performance and comparative resilience amongst emerging market peers may be thwarted by locally incubated ailments. But longer term economic dynamics appear broadly conducive to India’s rising importance on the Australian export league tables.
Turkey — escalating geopolitical risks expose economic vulnerabilities
Protracted political instability and a deteriorating security situation have dimmed the economic outlook and raised the risk of a crisis. Turkey’s economic vulnerability stems from a heavy reliance on fickle portfolio inflows to fund large external financing needs amid a highly volatile global market.
Political uncertainty created by inconclusive June parliamentary election is likely to persist beyond a snap poll scheduled for 1 November. Latest polling suggests a similar electoral impasse will result from fresh elections — where the incumbent Justice and Development Party (AKP) wins the election but fails to gain a parliamentary majority. A highly unstable AKP-led coalition is therefore the most likely longer term outcome which may curtail the already sluggish reform agenda.
Increasing conflict with Turkey’s Kurdish minority in the south-east of the country is another problem. Nationalist crowds have stormed Kurdish businesses and districts and President Erdogan has vowed fierce retribution in response to increasing attacks on Turkish soldiers and police by Kurdistan Workers' Party (PKK) guerrillas. A push against Islamic State and an influx of Syrian refugees on the southern border is adding to security risks.
All these factors are undermining the economy. Real GDP growth decelerated from an average of 6% p.a. during 2010-13 to 3% in 2014. Turkey’s solvency position has worsened sharply due to a large current account deficit and heavy foreign exchange borrowing that facilitated a domestic credit boom. Debt servicing has jumped from less than 25% of export earnings in 2012 to an estimated 40% in 2015.
Higher debt has encouraged an overreliance on notoriously volatile portfolio capital inflows that leave the country vulnerable to foreign investor sentiment and evaporate rapidly in response to shocks. These could come from tighter global liquidity in the wake of higher US interest rates, continued or worsened political instability, or the escalation of violence. Already, record lira weakness and higher risk premiums (Chart 3) are raising rollover risks and making debt repayments more difficult. Bond outflows have totalled over US$4b this year.
Risk of crisis is increasing in the world’s 17th largest economy and Australia’s 35th largest export market.
Trade slowdown to persist but too early to call ‘peak globalisation’
The global trade recession is fuelling debate over whether ‘peak globalisation’ has been reached. Both cyclical and structural forces are driving the slowdown but several factors could boost trade intensity over the longer term.
Global trade grew by 7% p.a. on average in the two decades preceding the global financial crisis. Yet since 2008, trade growth has been anaemic and lagged the expansion of world output (Chart 4).
New data show trade is actually now in outright recession — after contracting in the first two quarters of 2015. This is fuelling debate over whether the world has reached peak globalisation. The IMF’s most recent forecasts see world trade volumes expanding by just over 4% in 2015. This is a modest acceleration from 2014 and a return to the historical relationship where trade growth exceeds GDP growth. But it still represents underperformance relative to the historical average.
Cyclical forces explain the global trade slowdown. Weak aggregate demand and uncertainty have characterised the post-crisis global economy. Underperformance of the Eurozone, which accounts for a third of world trade volumes, has also depressed the data. But a secular shift down in trade intensity, caused by the following structural factors, is also to blame.
- The internationalisation of supply chains and cost efficiencies of containerisation are losing momentum. For instance, China’s share of imports into developed economies has flattened at around 15-20%. China's competitiveness has fallen due to wage inflation and a stronger exchange rate.
- Domestic integration of the Chinese market has caused the export component of China’s output to shrink. This trend will strengthen as authorities rebalance from investment and exports to a more sustainable consumption-driven model of growth.
- ‘Onshoring’ by Western companies has increased to cope with new environmental and geopolitical risks — and to take advantage of wage stagnation.
- Recourse to trade protectionism has increased in some markets.
- The global shift to services has depressed the importance of tradable goods.
These factors will continue to damp global trade — but several longer term developments mean it’s too early to call peak globalisation. For instance, new e‑commerce technologies are lowering the transaction costs for SMEs to export. The increasing international division of labour in regions not yet integrated in global supply chains — including South Asia, Africa and South America — may also boost global trade volumes. We’ve also argued previously that Australia will be insulated from the slowdown phenomenon by our relative isolation from global value chains.
Thailand’s democracy in limbo
The military-led government is set to remain in power after the draft constitution was rejected by the committee set up to steer reforms. The vexed political setting will add further headwinds to the slowing economy.
The draft constitution has received plenty of criticism, including from the two major political parties for being undemocratic. The draft constitution included an article creating special powers for a ‘crisis committee’. The committee would have been entitled to take power in the event of a crisis and to take any action with a two-thirds majority vote of its members—undermining democratically elected governments.
Yet without a constitution a fresh round of elections cannot be held, keeping the army in power for longer and delaying the return to democracy. Adding to the political uncertainty is the recent terrorist bombing in Bangkok. The military leadership promised to maintain law and order after it staged its 2014 coup, but the recent bombings challenge the government’s ability to deliver on that promise.
On top of these political problems is a slowing economy. Growth slowed to 2.8% y/y in the second quarter, following the 3% recorded a quarter earlier. Not surprisingly consumer and business confidence is running well below long run averages. The government is hoping to increase spending to lift growth to 3% over 2015. But the outlook will be plagued by slowing domestic and global demand.
Cassandra Winzenried, Senior Economist
Fred Gibson, Economist
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.
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