China ratchets up pro-growth measures, delaying overdue deleveraging

Premier Li Keqiang has laid out key economic targets for 2016 at the National People's Congress (NPC). A punchy GDP growth target of 6.5–7% will require looser fiscal policy and faster credit growth, at the expense of delayed reforms to address excess debt and industrial overcapacity. If the package boosts growth, it will be advantageous to Australia, but the effects shouldn’t be overstated.

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While lower than last year’s 7% target, the range demonstrates the government’s resolve to hold growth at robust levels. The target is consistent with previously defined goals of doubling GDP and income per capita between 2010 and 2020 and creating 10 million urban jobs a year.

Achieving these targets will require an enormous effort from fiscal policy. Premier Li ruled out 2008-like stimulus, but the target was raised to 3% of GDP (from 2.3% last year).[1] The government will invest RMB800b in railways, RMB1.65 trillion in roads and launch 20 hydro projects. Yet this year’s fixed asset investment growth target was actually lowered. Instead, much of the fiscal push will come from tax cuts to private firms — authorities are aiming for just 3% growth in budget revenue, down from 7.3% last year. Combined, these measures will cushion millions of workers retrenched by inefficient companies in heavy industry — around 15% of the coal and steel workforce are slated for layoffs.

The deteriorating outlook coupled with very low inflation have prompted monetary easing by the central bank. As such, credit growth reached a record US$385b in January. This month Moody’s revised its outlook on China’s Aa3 rating from stable to negative (bringing it into line with other rating agencies), citing concerns over rising debt and falling international reserves. Yet the money supply growth target was increased to 13% this year. Continued easing will be required to achieve it, though at a more gradual pace.

For the supply side of the economy, the authorities stressed the importance of reforms to address overcapacity in low-end and inefficient industries. They also affirmed the need to improve market-based incentives and lower barriers to entry in energy and labour intensive industries such as steel, glass, cement and aluminium manufacturing.

Any good news on Chinese growth should be a plus for Australian exporters, but enthusiasm should be tempered, particularly about the effect on commodity prices. Iron ore prices jumped a record 19% after the NPC, probably in anticipation of the stimulus boosting steel demand. Yet in reality, mounting low cost supply from Australia and Brazil and decelerating Chinese demand remain. As such, Goldman Sachs has forecast a drop back to $US35/t this year. While bad news for Australia’s overall trade balance — iron ore is Australia’s largest export — any price declines should ease upward pressure on the AUD, and boost the competitiveness of non-mining exports.


Schengen collapse threatens increased costs for Australian traders

The largest refugee crisis since World War II is threatening the Schengen system of open borders within Europe. Collapse of Schengen would impose economic, political and social costs on members and increase the transactional costs of trade for Australian exporters.

The 30-year old Schengen system of open borders allows for the free circulation of people and goods among 26 European countries (Chart 1). As major as this achievement is, it looks in danger of dismantlement. Conflict in Syria and elsewhere in the Middle East has triggered an unprecedented wave of refugees. In reaction, France, Germany, Austria, Sweden, Denmark and Slovenia have reintroduced temporary internal border controls. If these suspensions are not reversed, by mid-year it is possible that Schengen will be suspended for two years. This would mark the first reversal of European integration in more than three decades.

Reintroducing internal border controls would impose economic, political and social costs on EU members. The European Commission estimates that the economic costs of full dismantlement could amount to €100b over 10 years. Morgan Stanley’s forecast is double that. They estimate up to 0.2% of the EU’s GDP could be erased — due to a 5% surge in cross-border travel costs, and a 20% fall in trade flows as border checks and waiting times are reintroduced. They emphasise that goods worth more than €2.8 trillion travel within the Schengen zone each year, while 1.7 million workers commute across EU borders each day.

But to date, internal border controls have been introduced selectively — focusing on controls that will stop refugees from Greece moving further into Europe through the Western Balkans route. If this selective introduction continues, costs will be lower. Nonetheless, sectors that operate on small margins or where transport is a high percentage of costs will be disproportionately affected. For instance, the agricultural and chemical sectors as well as the transport of raw materials. Australian exporters will not be exempt — with higher transactional costs of trade resulting for our wares through affected borders.

Yet the economic costs are likely to be dwarfed by the wider social and political implications. The closure of borders could threaten the viability of the monetary union by eroding solidarity and trust among members. Disorderly political developments would dent private sector confidence and investment spending while reducing Europe’s resilience to economic shocks. This could derail the tentative economic recovery at long last underway in Australia’s third largest export market.

China — new regulations open up the lucrative e-commerce market

Australian exporters face increasing opportunities from China’s new cross border e-commerce laws.

China is set to extend foreign access to e-commerce in 12 new zones ─ Tianjin, Shanghai, Chongqing, Hefei, Zhengzhou, Guangzhou, Chengdu, Dalian, Ningbo, Qingdao, Shenzhen and Suzhou. This follows a successful trial in Hangzhou where e-commerce giant Alibaba is headquartered. Currently foreign goods imported outside these e-commerce zones are subject to lengthy waiting times and taxes. But under the new regulations foreign goods will clear customs at a faster rate and will need to pay only postage tax (average of 12%) after gaining exemption from VAT, consumption tax and other import duties.

Demand for foreign goods has grown strongly, spurred by the rising middle class. But as in other countries, the growing cost advantage of shopping online has caused households to shift their spending away from traditional brick-and-mortar stores. China has the largest online retail market in the world with online sales equivalent to roughly 12% of total retail sales, compared to 7.5% in the US and 7% in Australia.

The Chinese online retail market is dominated by Alibaba, which has an 82% market share. But the government has accused it of selling counterfeit goods. Chinese middle-income households are demanding genuine goods and are less willing to tolerate fakes. This opens the door for foreign business hoping to sell their goods online, particularly SMEs, who often don’t have the resources to set up stores in large cities.

Iran — new opportunities amid old challenges

Gains for moderate and reformist politicians in recent elections along with sanctions relief have improved economic prospects. But the oil price slump threatens to thwart any recovery before it gets going.

The nuclear deal and associated sanctions relief have improved the economic outlook. Higher oil exports, access to foreign assets previously frozen, and reduced frictional costs of doing foreign trade are forecast to lift economic growth, now around zero, to around 5½% next year. Iran’s relatively diversified economy is the second largest in the region. It has a huge industrial base and a large, young and educated population. Iran also has 18% of the world’s proven gas reserves and 9% of oil reserves. Without sanctions, it is likely to attract considerable foreign interest — authorities aim to draw in US$30b-50b in foreign capital over the next five years.

The slow but unmistakable evolution toward a more moderate political landscape is also likely to encourage investors. In elections last month, reformists dominated preliminary results — moderates secured 87 parliamentary seats (twice the number in 2012); followed by hardliners with 78 seats. Moderates and their potential allies also took about two-thirds of seats on the Assembly of Experts, a body that chooses the Supreme Leader. These results should provide support for President Rouhani’s ambitious economic liberalisation and international engagement agenda.

But oil prices are at 12-year lows and the economy struggles with high inflation and unemployment, weak bank and corporate balance sheets, sizeable government payment arrears, and large infrastructure efficiencies. Concerns about residual US sanctions, limitations in the legal system, widespread corruption, rife foreign exchange rationing and an inflexible labour market will also damp confidence. The World Bank ranks Iran 118 out of 189 countries on its Doing Business gauge, while it scores a lowly 136/175 in Transparency International’s Corruption Perceptions index.

On the political front, hard-liners still control the most powerful institutions — wielding veto power over parliament and dominating the judiciary, the security and armed forces, intelligence agencies and cashed-up religious business foundations. Conservatives continue to oppose the nuclear deal and new oil and gas contracts. The volatile regional situation — including rising tensions with Saudi Arabia centred on wars in Syria and Yemen — is also a continuing concern. Despite economic and political breakthroughs — Iran will remain a challenging market for exporters. 

Brexit — Britain’s trade post referendum

A June referendum that could loosen ties between the world's fifth largest economy and its biggest market is expected to be a close race. Whether Britain stays in or leaves, the EU will remain a key partner. But the precise impact on the UK’s trading economy will depend on the terms of the departure.

Prime Minister David Cameron has renegotiated the terms of UK membership of the EU — securing exemptions from ‘ever closer union’ and protections for the UK’s financial sector. The deal boosts the ‘stay’ camp ahead of the June referendum. But opinion polls remain split.

Economists and markets are more decided. In a recent Financial Times poll of over 100 economists, three-quarters thought Brexit would harm medium term economic prospects, while only 8% thought Britain’s economy would benefit. The Bank of England cautions that exit is the greatest domestic risk to UK financial stability — the pound has already fallen to its lowest level since 2009. Moody’s warns that voting to leave would threaten the UK’s credit rating, damaged by heightened uncertainty that would frustrate confidence and investment.

Trade is at the core of Brexit. Those opposed to the common market in Britain’s 1975 referendum were protectionist. In stark contrast, the current leave campaign focuses on freer trade. They argue that unshackled from EU law, Britain will negotiate a new EU trade deal and secure other trade deals with important markets like China and India. Meanwhile the stay campaign argues that EU membership allows Britain’s exporters to avoid tariffs and red tape within the EU, while outside it can win better terms thanks to the EU’s economic might. They also argue that membership has increased competition, innovation, specialisation and access to skilled labour.

Whether Britain decides in or out, the EU will remain a key partner. UK exports to the EU have trended down over the past several years but still account for almost half the total (Chart 2). In reality, the medium term impact will depend on the terms of the renegotiated trade association. Bolstering the UK’s negotiating strength after any exit is the proposition that the EU needs Britain — after all, the UK economy has grown faster than the EU average for several years and is a major conduit for FDI; the rest of the EU attracts only just over twice as much FDI as the UK. But while the EU takes almost half Britain’s exports, Britain takes just 6% of the EU’s. If Norway and Switzerland are a guide, the EU will demand the free movement of people and large budget transfers before allowing unfettered market access — rules Eurosceptics are keen to dump. And the EU would have an incentive to impose a harsh settlement to discourage others from departure. The medium term trade prospects following Brexit are uncertain at best.

Fiji — Cyclone Winston raises economic risks

Cyclone Winston, the largest cyclone to make landfall in the southern hemisphere, ripped through Fiji in late February. It could push the country into recession.

The death toll currently stands at over 40 people with approximately 54,000 people (6% of the population) still housed in evacuation centres around the country─90% of structures were destroyed in the hardest hit-areas. The cyclone also damaged transport, water, sanitation and electricity infrastructure.

The total cost of Winston is estimated at US$470m—10% of GDP. This includes lost output from agriculture and tourism, and damage to public infrastructure and schools. Funding the reconstruction could prove difficult as insurance payouts are currently estimated at US$47m. The other 90% will need to come from the government, foreign donors and the private sector. The IMF were expecting the government budget to fall to 3% of GDP in 2016, from 6% a year earlier. But the cost of reconstruction could push above 6% this year.

The IMF were forecasting growth of 3.7% in 2016, but widespread damage could push the economy into recession, at least in the short term. Research suggests that short run effects of large disasters on growth are always negative. This assumes the setback to Fiji’s tourism and sugar dependent economy will outweigh the positive impact of reconstruction efforts.

Fiji is Australia’s second largest trading partner in the Pacific behind Papua New Guinea. Australia exports mostly wheat, meat and manufactured goods to Fiji.

Papua New Guinea — budget woes and FX shortages worsen

Fiscal woes and foreign exchange shortages are getting worse.

The O’Neill government announced spending cuts late last year in response to a bulging budget driven by the slump in commodity prices. But the government’s financials could be weaker than expected with reports emerging of civil servants and suppliers with government contracts not being paid. Furthermore the Ministry of Finance has sent out a directive that cheques written in 2015 will need to be reissued or risk being dishonoured.

Foreign exchange reports are similarly grim with the shortage of hard currency reportedly remaining a US$1b problem. This means many exporters to PNG are unable to convert their kina earnings into foreign currency. This in turn is limiting trade finance available to some exporters. Australian exports to PNG fell 21% in 2015, following a 13% decline in 2014. The lack of foreign exchange plus lower demand for capital goods following the completion of the PNG LNG project have weighed heavily on Australian exports. 

Understanding negative interest rates

The impact of negative interest rates on Australian exports will probably be slight.

The European Central Bank recently reduced its main monetary policy rate by 10 basis points to -0.4%. But the ECB isn’t the only central bank with negative rates as policymakers in Japan, Denmark, Switzerland and Sweden are all employing a similar tactic.

So what are negative rates and why do these central banks have them? In the face of slowing global demand, countries with already near-zero policy interest rates have decided to start charging interest on bank deposits. Traditionally the central bank would pay banks interest on their deposits, similar to how we earn interest on deposits at our banks. But with negative interest rates depositors are instead charged interest. This is to encourage banks to lend money to the real economy, instead of parking it with the central banks. Theoretically negative interest rates also put downward pressure on the currency as investors look offshore for more lucrative investments.

Stronger private sector lending and a lower exchange rate should theoretically lift domestic demand and a country’s export sales, both key drivers of growth. But simply giving everyone cheap credit doesn’t always spur greater investment spending and consumption. New investments must still earn a return greater than a business’s internal hurdle rate; hard to do when growth is weak. And consumers are wary of taking on debt especially with the deleveraging cycle going on across most of the developed world. Indeed, Europe and Japan’s struggles post-GFC suggest pump priming the economy with cheap credit may not be enough to drive a stronger recovery.  

How will Australian exporters be affected? The Euro area recovery is growing at a snail’s pace—the IMF expects growth to accelerate to 1.7% p.a. in 2016, up from 1.5% a year earlier. Japan’s outlook is also weak with growth forecast at 1% in 2016, up from 0.6% in 2015. But the weak recovery should not subtract from the demand for Australian exports. Instead the lower AUD will drive exports, particularly those in the non-resource sector. The AUD has depreciated against the yen and most European currencies, despite the monetary easing in those economies. Why? Because the sharp fall in commodity prices has more than offset the effect of negative interest rates.

Looking ahead, the lower AUD will probably continue to support the competitiveness of our rural and manufacturing exports to both Europe and Japan. Consistent with broader trends, rural exports to Japan rose 17% p.a. in the 2015 financial year, and 7% to Europe.

Fred Gibson, Economist

Cassandra Winzenried, Senior Economist

[1] While there is no official estimate of the augmented fiscal budget (including local governments and policy banks), the IMF guesses that it is already at or above 10% of GDP.

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.