Monthly Archives: September 2011

The Weekly Mishmash: September 30

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1.   Indonesia: Cyclical Stress from Funding Linkages, but Structural Story Remains Intact

By Devi Tan & Seen Meng Chew, Morgan Stanley

Tan and Chew look at the ways a global growth slowdown could hit Indonesia. They conclude trade linkages are unlikely to be a major conduit given Indonesia’s strong domestic demand orientation. But the economy remains vulnerable to global risk aversion (albeit less so than a few years ago). Despite the possibility for near-term turbulence, they remain bullish on Indonesia’s medium-term growth prospects.

EM Muser: This story applies to other EMs as well, with Brazil and Turkey fitting a similar mold. Like Indonesia, they are big emerging markets with large populations and strong domestic demand. And, like Indonesia, they remain vulnerable to global risk aversion, at least in the near-term.

Turkey, in particular, looks vulnerable to external funding shocks. The ratio of short-term external debt to fx reserves is close to 100%. Indonesia has a high ratio by ASEAN standards at over 30%, according to Tan and Chew.

2.    Unprecedented situation in Hungary’s bond market

By Portfolio.hu (free registration may be required)

“Hungary’s State Debt Management Agency (ÁKK) received only HUF 30.2 billion in bids for a proposed HUF 40 billion debt issue in 12-month zero-coupon treasury bills (D120822) on Thursday. This marks a historic record low bid-to-cover ratio for the 12-month facility since January 2000 (since when data are available) and the lowest volume of total bids since April 2003…”

EMMuser: Not looking good for Hungary. As I’ve detailed in a number of posts, the economy has a host of longer-term structural problems, accompanied by a government in denial, and investors seem to finally be waking up to that fact.

3.    Copper Rout Outpaces Analysts Focused on Shortages: Commodities

By Maria Kolesnikova and Agnieszka Troszkiewicz, Bloomberg

(Hat tip David K.)

“Copper, which reached a record $10,190 on the London Metal Exchange in February, sank to $6,800 on Sept. 26, a 14-month low. The contract traded at $7,067.50 today, taking this year’s decline to 26 percent. The metal is on track for its second- worst year in almost a quarter century, exceeded only by a 54 percent retreat in 2008.”

Blogger Barry Ritholz shows a nice chart that suggests copper’s downturn is one more signal that we’re headed for another global recession.

EM Muser: While the sharp fall in copper prices may signal global recession, it will have a more direct effect on certain EMs, particularly Chile, which is still very much copper country. Chile is the world’s largest copper supplier, producing roughly a third of global supply. (See my earlier post: Chile: Latin America’s Wunderkind)

4.    Poland’s elections: cause for concern

By Jan Cienski, Beyond Brics

“[R]ecent opinion polls are showing steady growth for the right-wing opposition Law and Justice party, threatening to introduce an element of political risk to assessments of the Polish economy and the Polish currency. A new opinion poll has Civic Platform, headed by premier Donald Tusk, with 36 per cent support, with Law and Justice (PiS) just behind at 32 per cent…PiS’s tumultuous two years in power from 2005-2007 were marked by populist economic policies and by bitter fights with Brussels, Berlin and Moscow that left Poland marginalised in the EU.”

EM Muser: Poland’s economy has shown remarkable stability in recent years. It was the only EU economy to avert recession in 2008-09 so one might think the ruling Civic Platform party would be a shoe-in, but it’s not.

This story provides a good reminder of why we should not take political risk for granted. Hungary’s a case in point. Commentators did not expect much of a shift in economic policy when the Fidesz government came to power in 2010, and that was a mistake.

 

IMF’s Latest Growth Forecasts for China Look Overly Rosy

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The overriding consensus is that China is investing at an unsustainably fast pace. The symptoms include empty malls, shoddily built railways and ghost cities. This investment-led growth model can’t continue indefinitely. The debate for most analysts is not if China will slow, but when and by how much.

As a result, I was surprised by the IMF’s latest forecast that shows growth remaining quite robust over the next five years. China’s economy is expected to grow by over 9% annually in 2012-16, as shown below.

Figure 1:  The IMF sees real GDP growing at an average annual rate of 9.4% over the next five years

Source: IMF World Economic Outlook Database, September 2011

At the same time, the IMF envisages investment falling only slightly as a share of GDP to 46.2% in 2016 from an estimated peak of 48.7% this year. That implies investment will continue to grow strongly (at an average annual rate of roughly 8%) through 2016, even though most analysts agree that China is already over-investing, such that capital is being directed toward activities (eg. ‘white elephant’ construction projects) that are doing nothing to enhance the country’s productive capacity and long-term growth potential.

Figure 2: China’s investment to GDP ratio is far and away the highest among the big EMs, highlighting the economy’s reliance on investment-led growth

Source: IMF World Economic Outlook Database, September 2011

Figure 3: The IMF does not expect any significant shift from the investment-led growth model over the next five years

Source: IMF World Economic Outlook Database, September 2011

I can appreciate the challenges the IMF faces in developing its forecasts. In the same way that it was hard to put a date on when the US housing bubble would pop, it’s also hard to time China’s slowdown and its severity. Nevertheless, a forecast of steady, above-9% GDP growth through 2016 appears overly rosy, especially considering a recent IMF report where the institution acknowledges the risk that over-investment poses to sustainable economic growth.

“[C]ontinued high investment could, down the road and absent sufficient progress in rebalancing, create excess capacity, given uncertain demand prospects in advanced economies, thus risking a hard landing that reverberates beyond China.” (See IMF Country Report, July 2011, pages 5-6) In effect, the IMF appears close to contradicting itself. Very little movement is expected in the investment-to-GDP ratio over the next five years, meaning the IMF does not expect any significant rebalancing toward consumption. At the same time, the institution foresees growth holding steady over the period.

What is interesting is that even the 12th draft of China’s five year plan for 2011-15 stands in sharp contrast to the IMF forecast. The plan foresees GDP growth slowing to an average of 7% annually and targets a rise in domestic consumption.

What Do Analysts Think?

Most China watchers believe some sort of correction is unavoidable, although they do not necessarily see a slowdown as imminent. A number seem to think  the breaking point could come soon after 2013 – a year of transition in the Communist Party leadership.

Patrick Chovanec – an economics professor at Tsinghua University – sees a slowdown as inevitable. “China will have a correction, China needs a correction.” He notes, “There is a tug-of-war between those who say keep lending and let growth continue, versus those who are more concerned about inflation and want to rein it in.” This sounds like the typical battle of words before a bubble pops.

Michael Pettis – a Wall Street veteran and finance professor at Peking University – also sees a slowdown in the offing, but not this year or next: “[A]s long as the Chinese government retains its capacity to raise debt we are not going to see a sharp slowdown in economic growth – at least until 2013.  Any indication that the economy is slowing too quickly will be met with a relaxation of credit controls, and the concomitant rise in investment will spur growth. “

Nouriel Roubini – the New York-based economist who correctly predicted the popping of the US housing bubble – is one of the brave souls to put a date (at least sort of) on China’s slowdown. He sees the bubble bursting after 2013, which is when the change in political leadership is due. “Once increasing fixed investment becomes impossible – most likely after 2013 – China is poised for a sharp slowdown.”

Hungary’s Latest Debt Relief Plan: From Bad to Worse

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Hungary’s government just passed an ill-conceived plan to help households saddled with foreign currency debt on September 9. Disturbingly, more than two-thirds of lawmakers (277) voted in favour. This follows in the wake of an earlier plan announced in May (See: Hungary Mortgage Relief: Another Move to Delay the Pain).

While the earlier proposal from May had some flaws, the bill just passed is downright reckless. It will do nothing to help the economy. It won’t even provide relief to the indebted households that really need it. The government appears to have hatched this plan with little consultation or warning, marking the latest in a string of erratic policy moves. Below I detail the bill and some of its many problems.

What is the Latest Mortgage Relief Plan?

According to the bill, Hungarians will be able to repay their fx-denominated mortgages in one go, at well below market exchange rates. However, they must do so by the end of this year. Banks will become the fall guys, getting hit with the exchange rate difference.

Figure 1:  Roughly 65% of the mortgage loans outstanding are foreign currency-denominated, mostly in Swiss francs

 Source: MNB (National Bank of Hungary)

As seen in Figure 1, the majority of outstanding mortgage debt is denominated in Swiss francs. Under the plan, households who borrowed in Swiss francs will be able to repay their mortgages early, in one lump sum, at a preferential rate of 180 forints per CHF. Meanwhile, euro borrowers will get the same deal, but with the exchange rate fixed at 250 forints per €. As seen in Figure 2, these exchange rates are well below current market rates.

Figure 2:  Exchange rates in the bill are far below market rates

 Source: Oanda

Preface

Before I delve into the multitude of flaws in this mortgage relief bill, I want to make a few things clear. First, I am not an unyielding advocate of banks. If anything, I’m quite the opposite. Banks in Hungary lent heavily in foreign currencies to households earning in forint. This was clearly unwise (aka downright stupid), but everyone seemed to ignore the flashing warning lights and there’s plenty of blame to go around. Banks, as well as households, should have known better. Meanwhile, the regulators proved to be asleep at the wheel.

Hungary now finds itself in an FX debt mess. Debt levels in local currency terms have ballooned as a result of the forint’s depreciation against the franc, which is constraining consumer spending. As households struggle to repay their loans, the number of defaults is on the rise, constraining banks’ ability and willingness to extend credit, which in turn further weighs on the growth outlook. (See: Hungary’s Vicious Circle: Anemic Lending and Weak Growth)

However, this bill addresses none of these problems and manages to create new ones.

Problems with the Bill

  • Unlikely to Help Borrowers Most in Need

The most glaring problem with this mortgage relief bill is that the borrowers most likely to take advantage of it are those who least need help to repay their loans.  As I noted above, only those who can repay their mortgages in one lump sum by year-end 2011 qualify.

Those who are more than 30 days in arrears with debt repayments (eg. those who are struggling the most) would be disqualified, according to Portfolio.hu. Basically, anyone unable to beg, borrow or steal the money would be left in the lurch. Some may be able to borrow in forints to repay their fx-denominated debt, but again, those most likely to get such loans would be those less in need of debt relief. According to news reports, the Economy Ministry only expects 10% of borrowers to participate in the programme.

  • Risk to Financial Stability

As economic research firm GKI notes, good debtors will likely take advantage of the plan to repay their loans at preferential exchange rates. This will reduce the outstanding stock of mortgage loans.  Meanwhile, the rest will struggle. As economists at CIB note (via Bloomberg), the struggling households could actually emerge worse off due to the weakening of the forint, which will increase their debt burden in local currency terms. As a result, bad loans (as a percentage of the total) will likely rise. This will likely dampen lending and undermine the already stunted economic recovery.

More directly, the bill forces banks to swallow the losses from fixing the exchange rate at below market rates. This will trigger serious bank losses, the size of which hinges on the number of borrowers who participate in the plan. These losses will further constrain lending and could result in financial instability if banks fail (or come close to failing) as a result.

  • Potentially Big Fiscal Costs

The bill runs the risk of deteriorating public finances in at least two ways. First, there is a good chance that the European Court of Justice will rule that the plan is illegal. According to portfolio.hu, the Justice Ministry believes Hungary may have to compensate banks for any incurred losses. This would add to Hungary’s already substantial public debt burden, which topped 80% of GDP at end-2010.

Second, Hungary’s sovereign credit rating is teetering on the edge of ‘junk’ status. All three major rating agencies rate Hungary at the lowest level still considered investment grade. S&P and Moody’s have Hungary on negative outlook, making a downgrade more likely than an upgrade in the near-term. Analysts at S&P have already expressed concern about the effects of this bill. If Hungary is downgraded to ‘junk’, it could be disastrous given the country’s hefty debt burden as it would likely trigger a big jump in borrowing costs, making it harder for the government to sustainably meet its debt service obligations.

  • Underscores Erratic Government Policy

Investors are starting to realise just how unpredictable the current Fidesz administration can be. Since coming to office in April 2010, the government has engaged in a private pension fund grab (see here) in addition to implementing temporary ‘crisis’ taxes on the banking, energy, retail, and telecom sectors (see here). These policies were implemented with little to no consultation or warning.

This bill fits with the government’s typical modus operandi as it was unexpected and launched with little advance warning. All of this makes for a very erratic policy environment that is starting to spook investors. Notably, balance of payments data showed a net outflow of direct investment in Q1 2011, even before this plan’s announcement.

Bottom Line

The Fidesz government may find this plan politically beneficially, at least initially, since  it makes the government look like it’s standing up to the banks in the defense of debt-laden households. However, this mortgage relief proposal offers few, if any, positives for struggling households, the beleaguered economy, or the health of the banking sector.

The households that are struggling will continue to have difficulty repaying their foreign currency-denominated debt (and could experience even more difficulty if the forint continues to weaken). The losses banks suffer as a result of the exchange rate fix could endanger financial stability. Lending is already stagnant, and this bill will further dampen banks’ ability and willingness to lend, which will constrain already slowing economic growth. Meanwhile, investors – concerned by the government’s erratic policy moves – are likely to direct their funds elsewhere. Overall, this bill is a lose-lose proposition.

Related Posts

Hungary’s Vicious Circle: Anemic Lending and Weak Growth

Hungary: Finally on Investors’ Radar

The Double Whammy: Debt and Demographics

Hungary Mortgage Relief: Another Move to Delay the Pain

Fitch Raises Hungary’s Ratings Outlook: Odd Timing

Hungary’s Vicious Circle: Anemic Lending and Weak Growth

Posted on by emmuser
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Credit growth in Hungary is depressed and stands in sharp contrast to the credit booms underway in other emerging markets. A precarious combination of rising nonperforming loans, unpredictable government policy and municipal woes will keep bank lending anemic for the rest of 2011 and likely beyond. This anemic lending, in turn, continues to hold back the economic recovery, leaving it ‘creditless’. As a result, Hungary finds itself in the midst of a vicious circle from which it will be difficult to emerge.

Figure 1: After contracting dramatically in 2009, lending activity shows no sign of picking up

Source: MNB (Central Bank of Hungary)

The Economic Growth-Bank Lending Nexus

Hungary’s problems are more than just cyclical as demonstrated by the fact that the economy has not rebounded from the global downturn in 2008-09. Even though growth has returned, real economic output remains well below pre-crisis levels, as seen in Figure 2 below. This stands in contrast to the strong V-shaped recoveries seen in most emerging markets. Anemic bank lending is both a contributing factor to, as well as a symptom of, this economic malaise.

Research indicates that the credit supply can have a significant effect on real economic activity (See analysis on VoxEU by Cappiello, Kadareja, Sorensen and Protopapa). With no major turnaround in bank lending on the horizon, this does not bode well for Hungary’s economic growth outlook.

Figure 2: Real economic output in Hungary remains below the 2006 level


Source: Eurostat

Why a Major Turnaround in Lending is Not on the Horizon

According to the latest quarterly survey of senior loan officers released in late August, Hungarian banks do not plan to increase lending to households or the corporate sector in H2 2011. The following factors all contribute to the weak lending outlook:

  • High levels of problem loans

The percentage of non-performing loans (those over 90 days overdue) continues to rise, as seen in Figure 3. The rise is particularly pronounced amongst foreign-currency denominated loans.

Figure 3: Non-performing loans jumped sharply in H1 2011 to over 10% of total loans

Source: PSZAF (Hungarian Supervisory Authority)

Hungarians have engaged heavily in unhedged foreign currency borrowing. As of June 2011, 68% of total household borrowing was in foreign currencies, mostly Swiss francs. For the six months through August, the Swiss franc gained over 13% against the forint, causing household debt burdens to balloon in local currency terms, which is making it difficult for households to pay back their debt.

The loan portfolios of Hungarian banks will likely experience further deterioration in coming quarters even if the Swiss franc stabilises as a result of the Swiss National Bank’s decision to enforce a fixed target rate against the euro. (See related Bloomberg article: Swiss Franc Ceiling May Fall Short of Healing Eastern Europe Mortgage Pain.) The ongoing rise in non-performing loans constrains Hungarian banks’ capacity to lend.

  • Unpredictable government policy

The Fidesz government unexpectedly imposed a windfall tax on the financial sector, amounting to HUF187bn (roughly US$1bn), in 2010.  As a result, the banking sector’s pre-tax profits for 2010 were less than a quarter of those registered in 2009. The tax will be in place through 2012 and “will impair the ability and willingness of banks to lend and will act as a drag on economic recovery, ” according to the central bank’s latest financial stability report (see p. 9).

The government’s recently announced mortgage relief programme, set to begin this month, also contains a number of elements that are bad news for banks. See my related post: Hungary Mortgage Relief: Another Move to Delay the Pain. Policy uncertainty is likely negatively affecting banks’ willingness to lend.

Moreover, the uncertainty surrounding government policy could spur foreign parent banks to shift funding from their Hungarian subsidiaries to others in the region with a better earnings outlook. For example, in the wake of the bank tax, Erste Bank CEO Andreas Triechl warned the government: “We’ll have ways of showing that you can’t do everything with us. We have other countries where we can invest more.” Such a reallocation of funds would further constrain bank lending.

  • Municipal woes

A large number of banks reported sharp deterioration in their municipal loan portfolios, according to the latest quarterly survey of senior loan officers. While banks’ exposure to municipalities was roughly HUF 1,000 billion, or 5% of total bank loans at end-2010, this is still significant. Almost all banks surveyed plan to tighten lending to local governments in H2 2011.

Local governments are facing problems paying back their debt due to the fact that they have borrowed heavily in foreign currencies, particularly the Swiss franc, and due to the fact that the typical 3-5-year grace periods for the principal repayment of the large chunk of bonds they issued in 2007-08 (amounting to HUF 550 bn) started to expire at the end of 2010. Nearly half of the bond exposure is estimated to expire by the end of 2011. Lower revenue growth is also a factor in local governments’ predicament. According to the latest senior loan officer survey, the ratio of restructured municipal loans and bonds may reach 10% of banks’ total exposure to the sector by the end of 2011.

At least two separate local government associations have requested a partial moratorium on loan repayments, according to a story in the Budapest Business Journal. This adds to the environment of policy uncertainty and highlights the inability of many local governments to meet their debt obligations, which in turn makes banks less willing to lend.

  • Another Complicating Factor: External Events

Hungary’s loan-to-deposit ratio remains high in international comparison, well over 100%, and is a major vulnerability. The ratio highlights the banking sector’s heavy reliance on borrowing to finance lending, rather than retail deposits, which are a much more stable source of financing. As a result, the banking sector is vulnerable to a liquidity squeeze caused by external events. If wholesale funding dries up, as occurred during the height of the global financial crisis and as may occur during an intensification of the eurozone crisis, then Hungarian banks will need to shrink their balance sheets and won’t be able to lend, which in turn will drag on economic growth and exacerbate any potential downturn.

Bottom Line
Hungary is in the midst of a creditless recovery. While GDP growth returned in 2010, real economic output remains below pre-crisis levels and bank lending remains anemic. Research shows that creditless recoveries tend to be slow and shallow (see VoxEU analysis by Claessens, Kose and Terrones), with average growth about a third lower than during a “normal” recovery (see IMF paper on Creditless Recoveries by Abad, Ariccia and Li).

The government can aid the credit recovery process by making its policy toward banks more predictable and by the implementation of structural reforms contained in the convergence programme, which include greater central government control over borrowing at the municipal level.

See Related Links:

Hungary: Finally on Investors’ Radar

Hungary Mortgage Relief: Another Move to Delay the Pain

Fitch Raises Hungary’s Ratings Outlook: Odd Timing

Is water the new oil? If so, who stands to benefit?

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“You never miss water until the well runs dry.” As the proverb points out, many of us take water for granted, even though it’s key to our survival. But Citi’s chief economist Willem Buiter doesn’t. He recently described water as “the world’s most important but also still most under-appreciated commodity and store of value.” See his excellent essay (on p. 18): Water as Seen by an Economist.

Why is Water an Increasingly Strategic Resource?

  • The world’s population is growing by about 80 million people a year, implying increased freshwater demand of about 64 billion cubic metres a year. Source: UN World Water Development Report
  • By 2025, 1.8 billion people will be living in countries or regions with absolute water scarcity, and two-thirds of the world population could be under stress conditions. Source: FAO
  • Freshwater is but a small fraction – less than 3% – of the total water on Earth. The rest is saltwater.
  • Of the freshwater on Earth, nearly 70% is frozen in the icecaps of Antarctica and Greenland, as shown in Figure 1 below.

Figure 1: Lakes and rivers make up less than 1% of freshwater and they are increasingly contaminated

Source: UN-Water

Potential for Water Wars

For some years, analysts have expressed concern about the potential for water wars, with nations going to battle over this increasingly strategic resource. The Economist touched on this issue just over a year ago. This week, author and professor Brahma Chellaney wrote an op-ed in the FT, pointing to rising tensions in Asia. She notes that China is in water disputes with nearly all of its neighbours and that water stress endangers Asia’s fast pace of economic growth.

Similar to oil, not all regions of the world are equally endowed with water resources and this fact will affect economic growth and political tensions in the decades to come.

Figure 2: The distribution of freshwater around the globe is highly uneven

Source: FAO

The Water-Rich and Water-Poor

The water-rich list is peppered with emerging market heavyweights, including Indonesia and Russia. Brazil tops the list, and South America seems to have a disproportionate share of water wealth relative to other EM regions.

Figure 3: Brazil, Russia and Canada have the largest freshwater resources in the world

 

Source: FAO

While China and India also make the water-rich list based on their large freshwater resources, it’s important to look at their bounty on a per-person basis. Given their large populations, their water wealth looks a lot more diminutive using this measure.

Figure 4:  China and India’s freshwater resources look more diminutive when viewed on a per-person basis

Source: FAO

Meanwhile, the oil-rich Middle East is home to a disproportionate number of water-poor countries.

Figure 5: Kuwait and Qatar top the list of water-poor countries

Source: FAO

Looking to the Future

Willem Buiter foresees a global market for fresh water within 25 to 30 years. According to Buiter, “Water as an asset class will, in my view, become eventually the single most important physical-commodity- based asset class, dwarfing oil, copper, agricultural commodities and precious metals.”

If Buiter’s vision proves true, will that mean South America – particularly water-rich Brazil – is headed for a future that involves commodity-driven wealth and the problems that go with it, similar to what we now see in the Middle East?