World Risk Developments late July 2016


Italy — Teetering banking system a fault line for European unity

View a summary of this month's edition.

The EU wants Rome to ‘bail in’ bank creditors to recapitalise the troubled Italian banking system. But as in Cyprus, the suggestion is causing public indignation, which is playing into the hands of the Five Star Movement, a party of Eurosceptics who want a referendum on EU membership like the British have had.

Sharp falls in Italian bank stocks followed Britain’s vote to leave the EU. Italy's bank sector index has fallen 16% since the Brexit vote, bringing losses this year to almost 50%.

Italy is the eurozone’s third largest economy and one of its weakest—characterised by poor economic growth, enormous public debt and an undercapitalised banking system. The economy has been moribund for years—real GDP isn’t expected to return to its pre-crisis peak until 2025, implying almost two lost decades (Chart 1). Amid deflation and stagnation, the banking system is burdened by US$400b of bad loans, equivalent to 18% of GDP or a third of the eurozone total.

Speculation has grown that ECB stress tests, due later this week, will show danger of a banking crisis. Italian Prime Minister Renzi argues that an injection of public funds is critical to restore confidence and stabilise the system. But this would flout new eurozone ‘bail in’ rules, which force shareholders and creditors to take losses before taxpayers. The problem is that strict adherence would be felt acutely by households—some €200b of Italy’s bank bonds are held by mum-and-dad investors. Last November, four small failing lenders were rescued via public funds, but this erased some €430m of junior debt held by 12,500 small savers, and instigated a political storm in the process. Italy is advocating for flexibility in applying the EU’s bail in rules—to allow the use of public funds to recapitalise vulnerable banks and to suspend burden sharing to prevent shareholders and creditors from paying controversial costs. But European malleability is yet to be tested.

A creditor ‘bail in’ would dash Renzi’s hope of winning a referendum on constitutional reform in October. Renzi argues the overhaul is essential to cure chronic political instability and implement reform. If the referendum is defeated, Renzi has vowed to resign. This could plunge the country back into greater political and economic uncertainty. Italy’s second largest party is the populist Five Star Movement, founded by comedian Beppe Grillo, who rightly or wrongly, sees the currency union as the root of economic woe. The movement has taken a commanding lead in opinion polls. In May, 48% of Italians polled would vote to exit Italy from the EU in a referendum, compared with 41% of French and 34% of Germans.

Australia sells just 0.4% of its exports to Italy. But following Brexit, there is an outside risk that Italy could become the EU’s next fault line—a wider bloc to which Australia sells 7.5% of its exports. And a bloc that is the largest trading partner of China, our largest trading partner. Aside from the trade impact, contagion to Australia could arrive via financial and commodity market channels. A global systemic shock of this magnitude is likely to spike volatility and demand for safe assets while dealing a blow to commodities associated with global demand—like coal and iron ore. Yet in the far more likely scenario, Italian banks will absorb bad debts, even at the expense of the inevitable drag on growth, without it precipitating a near term crisis.

Turkey — Coup plot exposes external vulnerabilities

Political uncertainty has risen following the failed coup against the Erdoğan government. In retaliation, the authorities have made mass arrests and are cracking down on opponents. The unsettled political environment will raise the risks of investing in Turkey, which could hinder the refinancing of Turkey’s large external debts.

The failed coup resulted in at least 290 deaths and mass arrests. There has been talk of bringing back the death penalty against those found guilty of treason. The international community have cautioned Turkey against doing so and using the coup as an excuse to round up opponents.

Rattled investors have sold the lira down 5% against the USD and the stock market down 11%, and bid up yields on Turkey’s sovereign bonds by 50bps. Turkey relies heavily on fragile short term capital inflows to fund its sizeable current account , equivalent to 4% of GDP in 2015. Souring investor sentiment could undermine these capital inflows and make refinancing its large short term external debts difficult—in a worst case this could spark a balance of payments crisis.   

Japan — Abe’s super majority paves way for reforms

Shinzo Abe’s ruling coalition has increased its majority paving the way for greater economic reform. But entrenched vested interests will delay critical reforms around the labour market and agriculture. Instead, the Prime Minister will likely up fiscal stimulus, providing a short term fillip. 

Prime Minister Abe’s Liberal Democratic Party-led coalition has secured a supermajority in the upper house, gaining control of 165 of the 242 seats. High on the PM’s agenda is an additional fiscal stimulus to break Japan out of its low growth and inflation environment. Since 2012 the government’s ‘quiver’ to tackle the economy, ‘Abenomics’, has centred on three arrows:

  1. aggressive monetary easing
  2. fiscal stimulus, and
  3. structural reform to spur private investment—key to sustaining long term growth.

The government has carried out its monetary and fiscal policy goals. But structural reforms have not been as forthcoming. The government has managed to lower corporate taxes and sign various free trade agreements to stimulate trade and investment. But reforms to agriculture and attempts to boost productivity and female employment have been lacklustre. Abe’s parliamentary majority should give the coalition more clout to pass these reforms. Yet vested interests in the agriculture sector, the majority of which form Abe’s power base, and labour laws and practices that favour older more established workers will make passing these reforms difficult. We expect the Abe government will up its fiscal stimulus, giving the economy a short term boost. But the medium to long term outlook will stay weak as much needed reforms will remain slow going.

China — Steel market reforms could slow Australian iron ore export volumes

Consolidating China’s loss making steel industry, particularly if it leads to lower steel output, could weigh on the strong growth of Australian iron ore export volumes. But Australia’s low cost of production will cushion the risk to export volumes.

China’s economic slowdown and its shift away from investment-led growth toward a more consumer and service-oriented economy is dragging on the demand for steel. Factor in falling steel prices and over-leveraged steel company balance sheets and the conditions are ripe for a consolidation of China’s large, but fragmented steel sector. China has around 1.2b tonnes of production capacity, 400m of which are surplus. Around 25% of this surplus has been exported, with Chinese steel export volumes rising 34% p.a. since 2013, relative to the 5.4% p.a. growth recorded over 2007-2013. The rest has been stockpiled. Chinese steel production fell 2.5% in 2015 after expanding 11.9% in 2013 and 2% in 2014.

Around 30% of Chinese steel producers, particularly smaller companies, are loss-making but have survived on state subsidies. Consolidating the steel industry will force the closure of higher-cost producers and create economies of scale. Reports suggest that a merger of Baosteel, the sixth largest producer worldwide, and Wuhan Iron and Steel Group, the 12th largest, is likely. A merger would produce a company that would rank second worldwide after Europe’s ArcelorMittal.

Lower Chinese steel production has stymied global iron ore prices—iron ore is a key input in steel. Growth in Australian iron ore export volumes have slowed over much of the last 24 months (Chart 2) from 30% p.a. to a still robust 7% p.a. Australia’s major iron ore producers have the lowest costs globally, which has helped them wrestle greater market share in China.

A consolidation of the Chinese steel industry, particularly if this led to lower steel output, would damp the demand for iron ore. But higher cost producers would likely bear the brunt of the slowdown as lower prices and softer demand begins to bite. Australian iron ore export volumes could experience softer growth, but the impacts should be cushioned by the lower cost of production of Australian iron ore producers.

Bangladesh — Attacks on foreigners may scupper textile industry

Extremist violence targeting foreigners could scupper Bangladesh’s thriving textile industry, the main driver of its economic success.

Political violence is ingrained in Bangladesh. Even so, the economy has clocked 38 consecutive years of growth. A political war between the supporters of the two main parties killed at least 115 people last year, yet the economy grew by 6.5%.

But that political violence is now being supplemented by extremist violence that seeks out foreigners. A siege of a cafe in Dhaka this month was the first large-scale attack targeting foreigners, who comprised 18 of the 20 dead. Bangladesh’s prospects depend on its booming garment industry, which provides 80% of exports and 4 million jobs. But all nine of the Italians killed in the cafe worked in the textile industry, and foreign retailers, including Uniqlo and H&M, have responded to the atrocity by suspending all but critical travel to the country.

A clue to the damage terrorism against foreigners can inflict on an economy is provided by Pakistan, which despite a strong comparative advantage in clothing production is absent from the world’s 10 largest exporters (Chart 3).

Australian exports to Bangladesh have grown steadily to reach A$960m in 2015 (0.3% total exports)—over half of which is agricultural commodities. Greater security risks are a blow for Australian exporters already operating there, and those keen to explore opportunities—namely in education, premium food and infrastructure.

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.  

Editorial Credit: deepspace /