World sharemarkets lost US$2 trillion, or 4.8%, in the 24 hours after the British electorate voted to leave the EU on July 23. In the week following the Leave vote, sterling was down 10.3% vs the USD. Yields on long term government bonds in the US, Germany and Japan have pushed deeper into negative territory. And the UK government lost its AAA credit rating. In Australia, the ASX/S&P200 has recovered most of the initial losses, while the AUD was down 2% against the USD.
Obviously, the Leave vote has created a lot of uncertainty. We will not know for some time what it will entail precisely, let alone its impact on Australia’s major trading partners and commodity markets. When will the UK ‘begin divorce proceedings’? And will the eventual divorce lead to a complete break, or some form of cohabitation—meaning continuing membership of the Single Market?
From a narrow trade perspective, the impact shouldn’t be that great, because Australia sells less than 3% of its exports (equivalent to ½% of GDP) to the UK. Companies that trade with the UK could, however, be hit hard in the short term, through both the depreciation of sterling and the drag that Brexit exerts on the UK economy. The longer term impact will depend on the ultimate terms of the UK’s trade relationship with the EU.
The broader trade impact is less clear. It looks likely that Brexit will damp growth in an already sluggish and financially fragile wider EU—an area to which Australia sells an additional 4% of its exports. The IMF estimates that Brexit could shave up to 0.5ppts off annual growth in the broader EU.
Looking to Australia’s major emerging market export customers, many could suffer significant setbacks through their trade ties with the UK and the rest of Europe. Vietnam, Saudi Arabia and Papua New Guinea look most exposed among Australia’s major trading partners (see table). Some will manage to cushion the shock through currency depreciations, but this doesn’t look to be an option for Japan, Saudi Arabia, UAE and China because of the strong upward pressure on the JPY and USD, and the peg of the CNY, SAR and AED to the USD (though China has begun to loosen its peg further).
We can’t confine our analysis to just the trade multiplier effects. There are also four other important factors to consider—the reaction of financial markets, the reaction of commodity markets, the reaction of policymakers, and the reaction of EU politicians and voters.
The Leave vote has prompted asset managers to move into safe assets. This has caused not only big appreciations of USD and JPY, but some increase in credit spreads on risky assets, which could put financially fragile companies and industries under strain if it goes further. Investors are also on edge that the Leave vote could trigger a large correction in share prices—beyond the small(ish) one that has already taken place. If that happens, negative wealth effects would damp world growth and trade.
In commodity markets, expectations of iron ore, coal and oil prices to 2019, as shown in forward pricing, have so far changed little.
Policymakers won’t sit idly by as Brexit exerts its negative influences; they will try to counteract them—a good thing. The snag is, they are running out of room to move—with interest rates at or close to the 'zero lower bound' in the UK and EU, and also in the US and Japan. As for fiscal policy, many authorities will be torn between wanting to administer some fiscal stimulus and holding back out of fear of credit rating downgrades.
The biggest imponderable is the effect Brexit will have on the wider European project. Eurosceptic parties in France, Holland and Italy have already called for us-too referendums. And Scottish politicians have called for another referendum on independence from the rest of the UK, after which they hope to take their country back into the EU.
The range of possibilities is wide-open, but in the most unsettling case the divorce proceedings are difficult and prolonged. We could also see the Eurosceptics get their way which would ultimately lead to more members leaving the European Union. This could cause significant financial market and economic pain not only in Europe but across the globe.
At the other extreme, the divorce proceedings go smoothly and the UK stays in the Single Market. Brexit forces the EU to fix its faults and the rest of the EU stays together. Investors now see risky assets as bargains and switch back into them. Thanks to firming demand and larger supply potential, a strong economic recovery gets underway.
Here is an IMF study canvassing adverse and benign scenarios, though it unfortunately restricts its forecasts to the UK.
Will China avoid a Minsky moment?
The ‘Minsky moment’ is the sudden stop to lending that happens when banks finally wake up to unsustainable debt accumulation. The game of ‘extend and pretend’ ends and a financial crisis occurs. China has unsustainable debt accumulation, but also the ability to write a lot of the debt down and start afresh. That room to move won’t last forever. How exactly a financial crisis could unfold however, is beyond anyone’s ability to predict.
Chinese corporate profitability is falling. due to a large debt overhang and excess capacity in ‘old economy’ sectors, along with the slowing domestic economy and subdued global demand. But despite worsening debt service capacity, strong credit growth continues. Outstanding private loans are estimated at more than 200% of GDP, up from 125% in 2008. Continued access to financing for state-owned enterprises (SOEs) and projects affiliated with local governments owes to an implicit government guarantee plus a lack of credit discipline. This has allowed weakening firms to run up large payment arrears with suppliers.
The IMF estimates loans at risk to be almost 16% of total bank loans to the corporate sector—equivalent to US$1.3tn. Assuming a 60% loss ratio, this equates to potential losses of US$756b (7% of GDP—more than double the costs of the 1998 bailout). But while this number is large, the IMF says it remains ‘manageable’ given existing ‘bank and policy buffers’ and continued strong GDP growth. The Chinese banking system is state-backed and domestically funded. Public debt is low (43% of GDP) and foreign exchange reserves remain large. There are few channels through which a foreign-induced debt sell-off could trigger a financial crisis akin to the one in Asia in 1997.
Yet weak corporate finances have increased risks in bond and equity markets and could add to capital outflows and exchange rate pressures. A series of initiatives have been launched to whittle back bad debts on banks’ balance sheets, including securitisation and debt-for-equity swaps. But the IMF has warned that growing corporate debt is a ‘key fault line in the Chinese economy’ which requires more policy gumption, to ensure that the cost of addressing the losses remains manageable and to avoid throwing good money into bad companies that should be closed.
Targets for growth of 6.5 to 7% up to 2020 in the government’s five-year plan places pressure on the Chinese bureaucracy and SOEs to deliver on growth. To the extent policy makers rely on credit channels, their doing so is not without growing risk.
Social unrest adds to PNG’s bleak economic outlook
Violent exchanges between police and students have added further uncertainty to an economy already suffering from weak commodity prices and foreign exchange shortages.
University students are demanding that Prime Minister O’Neill resign over allegations he interfered with investigations into A$30m missing from government coffers. Their protests were met with force by authorities and although no one was killed, at least 17 students were injured in the exchange. Businesses were also forced to close and workers were sent home for the day. Protests have been heavily concentrated in the two largest cities, Port Moresby and Lae. The protests add increasing uncertainty to a slowing PNG economy beset by slumping commodity prices, severe cuts to health and education programs and foreign exchange shortages. PNG was amongst Asia’s fastest growing economies in 2015, expanding an impressive 10% p.a. But forecasts from the Asia Development Bank for 2016 and 2017 are less optimistic with growth expected to slow to 3.4% in 2016 and 3.6% in 2017.
Foreign exchange shortages are weighing heavily on Australian exports into PNG as PNG importers struggle to convert their kina earnings into AUD. Export receipts from PNG fell 22% in 2015, led by lower mining and energy exports (down 78%) and weaker manufacturing exports (down 6%). Receipts are likely to contract further in 2016 as exports in the year to April are down 11% from the same period in 2015.
The Panama Canal upgrade unlikely to increase US LNG supply into Asia
The expansion of the Panama Canal will unlikely be enough to encourage stronger US LNG exports into Asia in the near term as the low price environment will dissuade US gas producers.
The expanded Panama Canal opened on June 26 will enable greater trade flows between Asia and the US. The US$5.4b expansion has doubled the canal’s capacity and more importantly allows for much larger ships to pass through, including LNG tankers. This would cut LNG shipping times to Asia by 11 days and potentially increase the supply of US LNG into Asian markets.
But the price differential between US and Asian markets doesn’t look to be enough to encourage US LNG into Asia. The price of natural gas in the US spot market is currently US$2.70 per mmbtu but including costs associated with liquefying the gas, so it can be shipped, and transport costs increases the price to US$7.70. This is higher than the current Asian spot price of US$5.30 and long term LNG contract prices in Asia— which are linked to oil prices—at US$7.00 per mmbtu. Gas exports across Asia are predominantly linked to oil prices, but pricing floors in LNG contracts mean buyers are not reaping the full benefits of lower oil prices. This has caused some of the bigger buyers, including Japanese utility companies, to renegotiate their LNG contracts and could force a greater shift toward the Asian spot market.
Based on current shipping costs from the US and demand for LNG from Latin America, the price differential between the US spot market and Asia’s spot market—the most likely market for US supply—needs to be greater than US$5.00 per mmbtu to make the trade attractive. But over a longer term horizon, the expiry of long term gas contracts in Asia, recovery in oil prices and new technologies to lower transport costs could increase the viability of US LNG exports into Asia.
Venezuela’s foreign exchange crisis costs Australian firms
Though Venezuela buys less than 0.02% of Australian exports and ranks only 45th among Australia’s outward FDI destinations, Australian packaging company Amcor has become caught in its economic crisis.
Amcor had profitably owned and operated six ridged plastic plants in Venezuela for nearly 20 years. But a $US350m write-down on its Venezuelan business will effectively delete the country from its balance sheet. The trouble is a severe economic crisis has caused a drought of foreign exchange, and this is impeding access to the USD Amcor needs to buy raw materials.
Slumping oil prices have compounded to spur Venezuela’s economic and humanitarian crisis—oil revenues account for 95% of export earnings, and nearly half of public revenue. The IMF forecasts inflation could blow out to 700% this year and the economy contract by 8%. While the write-down caused Amcor’s shares to fall 8%, the company has affirmed its belief in the long term attractiveness of emerging markets. Yet the Amcor case highlights the risks involved in investing in highly commodity dependent emerging markets besieged by weak institutions and governance.
Fred Gibson, Economist
Cassandra Winzenried, Senior Economist
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