The good news is I have a new job. The not-so-good news is that I’ll no longer have time to blog. But if you’re interested, you can still follow me on Twitter – @emmuser.

Parting Views

First, as we know, not all emerging markets are created equal. These economies exhibit widely varying degrees of health, making the term ‘emerging market’ somewhat of a misnomer. I often use it for lack of a better term. But some, such as Hungary, are really better classified as ‘submerging markets.’

Second, there is a tendency to focus attention on short-term economic indicators: monthly industrial production, quarterly growth, the next monetary policy meeting, etc. But politics very much matters…what seem like relatively minor changes in the political environment often foreshadow negative turns in the investment climate and are worth monitoring (eg. restrictions on the media).

Third, I think the EMs with the brightest medium-to-long term prospects have the following common denominators:

• large internal market
• favourable demographics
• limited debt burden
• natural resources
• smart policymaking
• demonstrable progress on structural reforms

Colombia and Indonesia largely fit the bill. While they’re not immune to a global slowdown, the factors above suggest they have a particularly bright longer-term future. (See Indonesia: Ugly Duckling No More and How Exposed is Colombia to a China Slowdown?)

Brazil also boasts many of the above factors, but one particular factor where I feel it’s still lacking is progress on structural reforms, which is why I ended up devoted a couple of blog posts to areas that appear ripe for improvement. (See Brazil’s Brain Gain Not Enough and Brazil: Time to Make Tax Reform a Priority)

I am less optimistic about economies in the CEE region as their demographic profiles bear a much closer resemblance to those in rapidly aging advanced economies. Hungary, in particular, stands out negatively. (See The Double Whammy: Debt and Demographics)

It has been fun. Goodbye for now!

The government has pursued a populist and nationalist agenda with little regard for international opinion. Most recently, parliament defied the IMF and passed controversial laws that effectively undermine the central bank’s independence (see here).

Previous policy moves have included the de facto nationalisation of private pension assets, a botched mortgage relief plan, greater media restrictions, curbs on the Constitutional Court’s powers and the hollowing of the Fiscal Council, a budgetary watchdog, among others. (See my posts: Hungary and Turkey: Political Parallels, Hungary’s Debt Relief Plan: From Bad to Worse and Hungary’s Ratings Downgrade is No Surprise)

So far, this policy strategy has paid off domestically as Fidesz remains the country’s most popular political party, as shown in Figure 1.

Figure 1: Despite falling support, Fidesz still holds a wide lead over its rivals

Source: Ipsos and Tarki

Economy watchers remain hopeful that an IMF deal is around the corner. Erste expects an agreement to be reached in Q2. UniCredit notes Hungary’s “limited FX and HUF government deposits” and says progress needs to be made in January. However, even if Fidesz swallows its pride and signs a new IMF deal out of economic necessity, don’t expect everything to become hunky dory.

Combative Relationship with the IMF

If reached, an IMF agreement would certainly be a positive for Hungary, helping to bolster investor sentiment and avert a sovereign default, but it would not be a panacea.  It’s unclear that the government would follow through and implement the tough conditions imposed by such an agreement. The government has had a turbulent, mistrustful relationship with the Fund, and this will not change overnight.

In July 2010, Hungary had a high profile falling out with the IMF due to the government’s unwillingness to reconsider its imposition of a controversial bank tax and to a lack of transparency over how fiscal targets would be achieved. (See Eastern Approaches blog post on the row.) Meanwhile, a number of Fidesz officials have made no secret of their disregard for the IMF, including Economy Minister Gyorgy Matolcsy, who said:

“We cannot attune [economic policy] to the IMF as they deeply object to all Hungarian decisions that are aimed at freeing the people from the shackles of the banks. This three-letter institution objects to every single measure we make, thus we are not attuning government policy to them, but against them.” (See Eastern Approaches: Where’s Gyorgy?)

Fragmented Opposition

Thousands recently took to the streets in a protest against the government. Nevertheless, the opposition in Hungary is unlikely to bring about political change. Support for Fidesz has fallen, but this disaffection has increased the ranks of undecided voters rather than bolstering rival parties, as seen in Figure 2 below. The only opposition party to see any noticeable increase in support is Jobbik, a far-right party known for its anti-Semitism. Fidesz looks reasonable by comparison.

Figure 2: Fidesz lost support in 2011, causing the ranks of undecideds to swell

*Polling was not conducted in March or August
Source: Median.hu

Changing the Rules of the Game

The next parliamentary election is not due until 2014 and Fidesz has already taken steps to retain its grip on power. For example, the party has enhanced its electoral prospects through gerrymandering (the redrawing of certain districts in its favour), which can only be altered by a two-thirds majority vote in parliament. (See Politics.hu article. For more in-depth analysis, read Alan Renwick’s excellent blog post on Hungary’s New Electoral Law or the guest post Hungarian Diplomatic Protest on Paul Krugman’s blog).

In addition to redrawing districts, the Fidesz administration has changed the rules of the game in other ways. (See FT op-ed by Philip Stephens: A Hungarian coup worthy of Putin) The effects of its power grab will likely endure for many years to come even if Hungarians vote the current administration out of office.

Bottom Line

Fidesz will remain Hungary’s dominant political party for the foreseeable future given the country’s weak opposition. Reaching a deal with the IMF will prove challenging given the government’s combative relationship with the Fund. Fidesz will likely balk at the conditions imposed. Even if a deal is reached, political risks will remain elevated as Fidesz is unlikely to fully implement IMF-imposed reforms.

• Hungary’s Ratings Downgrade is No Surprise
• Hungary’s Latest Debt Relief Plan: From Bad to Worse
• Hungary’s Vicious Circle: Anemic Lending and Weak Growth
• Hungary: Finally on Investors’ Radar
• Hungary and Turkey: Political Parallels
• Fitch Raises Hungary’s Ratings Outlook: Odd Timing
• The Double Whammy: Debt and Demographics
• Is CEE Better Prepared This Time Around?

However, a continuation of this performance is unlikely. Peru has achieved impressive growth, at least in part, by riding on China’s coattails. This contrasts with Colombia, whose direct ties to China remain very limited. (See: How Exposed is Colombia to a China Slowdown?)

Going forward, Peru’s economic fortunes largely rest on the outlook for China and on how global commodity demand shapes up.  As China’s growth looks set to moderate, so will Peru’s. (See: IMF’s Latest Growth Forecasts for China Look Overly Rosy) Moreover, Peru could really hit the skids if the Middle Kingdom’s hearty appetite for copper and other metals substantially diminishes.

Trade with China

Exports to China have risen steadily and helped propel the economy’s fast growth. The two countries signed a bilateral free trade agreement that entered into effect in March 2010, further strengthening their trade ties. In 2011, the Asian giant became Peru’s biggest market. China now accounts for 16% of the country’s total exports, as seen in Figure 1 below. This is not an incredibly high percentage, but it’s still significant.

Peru’s export markets are pretty diversified relative to others in the region. For example, over 40% of Colombia’s exports go to a single market, the US. (See: How Exposed is Colombia to a China Slowdown?) Nevertheless, Peru’s growing trade dependence on China means its economic fortunes are increasingly tied to Chinese demand.

Figure 1: China has surpassed the US as Peru’s top trade partner

Source: Promperu

Investment from China

China’s direct investment in Peru is among the highest in Latin America, as shown in Figure 2. Almost all of this investment has gone into the country’s mining sector. According to data from Peru’s investment promotion agency, Proinversion, Spain and the US remain the biggest direct investors in the country, but that could change.

Peru’s Prime Minister Salomon Lerner expects Chinese direct investment in Peru to increase by 30-40% in 2012-13 (See related article from Andina). Of course, that assumes strong Chinese demand for the country’s resources continues.

Figure 2: Peru received more Chinese investment in 1990-2009 than any other Latam country

Source: ECLAC*

*ECLAC’s analysis of Chinese FDI is based on data collected from companies and on data provided in announcements of investments and M&A activity, more than on official BOP data.

Global Commodity Demand

Mining is an important economic driver in Peru, and China’s seemingly insatiable demand for commodities has propelled metal prices upward. But will it last?

Liam Peven of the WSJ outlines three potential scenarios for commodities based on: 1) continued robust growth in China, 2) a soft landing (mild slowdown), 3) a hard landing. (Note: I don’t see scenario 1 happening, but clearly the WSJ is more optimistic than I am).

Peven does warn, “Demand for steel, copper and other industrial metals could drop significantly if China does stall, because those materials are heavily used in construction—which would be at risk from weakness in the Chinese real-estate market—and because China often accounts for some 40% of global demand for those materials.” (See WSJ article: As China Goes, So Go Commodities)

Metals – led by copper and gold – generated 60% of Peru’s export revenue in 2010, as shown in Figure 3. Not only does mining drive the country’s exports, it also feeds into domestic demand in the form of job creation and investment. As a result, a downturn in China would have far-reaching effects on Peru’s economy. Notably, gold prices tend to move differently than those of other metals given gold’s perception as a safe haven, which could provide Peru some comfort.

Figure 3: Copper and Gold dominate Peru’s exports

Source: PromPeru

On the Bright Side

Clearly Peru is vulnerable to a slowdown in China, but there is some good news. Policymakers have taken advantage of the boom times to lower the country’s public debt-to-GDP ratio and to bolster the country’s competitiveness through growth-enhancing reforms.

As seen in Figure 4, public debt has fallen from 47% of GDP in 2003 to 25% in 2010. Notably, the debt ratio fell even amid the global downturn in 2008-09. Meanwhile, Peru ranked 36th out of 183 countries in the World Bank’s 2011 Doing Business Survey, which is ten places higher than last year’s ranking. Among the many reforms, the government made it easier to start a business and simplified the process to register property. This is very positive and will boost Peru’s longer-term growth potential.

Figure 4: Peru’s public debt ratio has steadily declined from a peak in 2003

Source: IMF

Bottom Line

Despite the positives mentioned above, Peru is among the most vulnerable of Latin America’s economies to a downturn in China. It would directly affect the Andean country through its strong trade and investment ties to the Asian giant and more broadly affect Peru through a fall in global commodity prices.

The EM economies most hit by the current spike in global risk aversion are those that attracted the largest inflows of ‘fickle’ capital in recent years. In response to financial market volatility, most EM policymakers have opted to let their currencies depreciate rather than tap foreign reserves.

Poland and Turkey have low foreign reserve levels relative to other EMs as seen in the Deutsche Bank chart, but Jäger believes they are still sufficient to avert a crisis. In particular, he points to Poland’s flexible credit line with the IMF, which reduces the economy’s vulnerability to a drying-up of capital inflows.

EM Muser: I looked at this issue in a post back in October: Which Emerging Markets Appear Vulnerable? A Look at Early Warning Indicators. Turkey, and to a lesser extent Poland, also stood out as vulnerable based on my analysis. In addition to low levels of foreign reserves, both are running current account deficits. Turkey’s is particularly large and is estimated to reach a very high 10% of GDP for 2011.

I agree with Jäger that the flexible credit line will help insulate Poland from crisis. However, I think Turkey looks quite vulnerable, at least in the near-term. Its high external financing needs leave it very exposed to a sudden stop in capital inflows. Right now it’s largely a confidence game.

2.  Indonesia: Land Bill to Help Infrastructure and Enhance ‘Structural Goldilocks’
Deyi Tan and Seen Meng Chew, Morgan Stanley

Indonesia’s parliament passed a long-awaited bill that will move forward much needed infrastructure projects on December 14, according to Reuters. Prior to its passage, analysts at Morgan Stanley detailed why this would be a positive step forward. They believe the increase in infrastructure spending will help raise Indonesia’s potential growth to around 7.0-7.5% by 2015.

EM Muser: As I argued in a post last month, Indonesia is a relative bright spot in today’s global economy. (See: Indonesia: Ugly Duckling No More.) The country boasts a large domestic market, a growing population, low debt levels, relative political stability and smart policy making.

The passage of this land bill represents another reason to be bullish on Indonesia especially since analysts viewed weak infrastructure as one of the major structural constraints on growth. The bill is also likely to prompt sovereign ratings upgrades. (December 15 Update: Fitch raised Indonesia’s credit rating to investment grade following the bill’s passage. Moody’s and S&P continue to rate Indonesia below investment grade.)

3.  EMEA Weekly: Russian election special – how much can you cheat?
Danske Bank

Following December 4 parliamentary elections, roughly 50,000 people took to the streets in the biggest protests in over a decade. The ruling United Russia party narrowly won with 47% of the vote amid widespread fraud allegations. The boiling over of dissatisfaction with the government surprised analysts and overshadowed news of the expected approval of Russia’s WTO entry later this month.

Despite the outpouring of anger, Danske does not expect widespread protests in Russia like those seen in the Middle East and North Africa earlier this year. Moreover, Danske still expects Vladimir Putin to emerge victorious in the March presidential election as “he is the only viable option.”

EM Muser: The protests spurred Russian billionaire Mikhail Prokhorov to announce himself as a challenger to Putin in the coming presidential race. Skeptics believe Prokhorov’s candidacy is government-sanctioned in an effort to defuse growing tensions. In any case, the March presidential race just got more exciting and political uncertainty in Russia will remain elevated.

4.  How the role of equities may shrink
McKinsey Global Institute

A new McKinsey report points to the transformation of emerging-market households into a powerful new investor class. Their share of global financial wealth is expected to rise from 21% to as much as 36% of global financial wealth by the end of 2020.

EM investors behave differently than those in mature economies and are less likely to invest in equities, according to McKinsey. “This shift is being exacerbated by aging and other trends in the developed world that are dampening investor appetite for equities. As a result, equities could decline from 28% of global financial assets in 2010 to 22% in 2020.”

EM Muser: If McKinsey is right, then demand for equities in EM markets will not keep up with supply. This, in turn, will raise companies’ cost of equity. While this is bad news for growing companies in these markets, it could result in higher returns for EM equity investors. (Unfortunately, I was only able to access the summary. If anyone is able to send me the full report, I’d greatly appreciate it.)

Influx of People

According to Brazil’s Justice Ministry, the number of immigrants jumped by 50% in the first half of 2011 to almost 1.5 million. Portuguese newcomers led the way driven by bad economic conditions at home. Their entries topped 328,000, up from 276,703 in the previous six months.

Meanwhile, Brazilians are returning to their native land in droves. The Justice Ministry estimates there are now only 2 million living abroad, a sharp drop from the roughly 4 million outside the country in 2005. For decades, Brazilians left in search of better opportunities abroad, but no longer. (See LA Times, Poets & Quants, FT’s Beyond Brics)

Still a Talent Shortage

High salaries have helped lure back returnees. Notably, executive pay in Sao Paulo surpassed that in NY and London in 2010, according to a Dasein Executive Search survey. (See: Executive Pay in Brazil: Top Whack.) Booming economic growth (at least until recently) and a strong currency explains part of the rapid rise, but not all of it.

A deeper, structural problem is also at work – a talent shortage. The inflow of immigrants and Brazilians moving back, while positive, is only a drop in the bucket. As seen in Figure 1, a majority of Brazilian employers reported difficulties filling open positions in 2011. Only in Japan and India did employers have more trouble.

Why such difficulty? Employers cite a dearth of quality candidates, who lack the necessary experience and technical skills, according to Manpower’s survey. The education system lies at the heart of the issue.

Figure 1: Brazilian employers have a hard time filling jobs compared with most other EMs

Source: Manpower 2011 Talent Shortage Survey

The Global Talent Index, compiled by headhunter Heidrick & Struggles in conjunction with the EIU, reaches similar findings to the Manpower survey. In the 2011 index, Brazil ranks a lowly 42nd out of 60 countries. The scoring is based on the following 7 factors:

• Demographics
• Compulsory education
• University education
• Quality of the labour force
• Quality of environment to nurture talent
• Relative openness of market
• Ability to attract talent

Figure 2: Brazil scored poorly in the Global Talent Index, behind China and India

Source: Global Talent Index 2011

Not surprisingly, Brazil scores very well in the demographics subcategory, given its large, growing labour pool. The country’s population is estimated at just over 190 million, the world’s 5th largest, but size isn’t everything. What drags Brazil’s score down is the quality of the labour force and its limited openness.

To assess labour force quality, the survey looks at the foreign language and technical skills of the workforce as well as the number of technicians and researchers involved in R&D. Brazil’s performance on these measures leaves plenty of room for improvement. Even though the country has a large pool of workers, many lack the skills needed to thrive in global companies.

Brazil also ranks poorly in terms of the relative openness of the market, but I see this as much less of a concern (*see my footnote below).

Economic Effects

Favorable demographics is an important, albeit insufficient ingredient for the economy to move to a higher growth path. Brazil needs to improve its education system to realise the potential advantage of its growing population. Not only is higher economic growth at stake if the skills shortage goes unaddressed. Inflation is also an issue. Brazil’s lack of qualified labour is one of the factors that has driven up wages and fueled broader price rises.

Education

Brazil has achieved a number of important education milestones in recent years. Primary education is almost universal, but there’s still plenty of room for improvement.

As seen in Figure 3, Brazilian students scored poorly in the latest PISA (Programme for International Student Assessment), a test given every three years in over 60 countries. Meanwhile, only five Brazilian universities rank among the 600 best in the world.

Figure 3: Brazilian students performed poorly on the PISA test, behind Chile and Mexico

Source: OECD

Part of the reason for Brazilian students’ poor showing is due to relatively low education funding. In 2009, Brazil spent less per student than other EMs, such as Thailand, Poland, Colombia and Mexico, according to OECD data. Throwing money at the problem will help, but it won’t be enough on its own.

BRAIN (an initiative supported by ANBIMA and Febraban that aims to turn the country into an international business hub) highlights specific steps to address the talent shortage and improve Brazil’s education system. Their broad recommendations are below. Read the BRAIN report (only in Portuguese) for more specifics.

• Focus more resources on secondary education (i.e. high school level)
• Improve the quality of teachers and incentivize them
• Revamp the school accreditation process
• Promote greater interaction between universities and the private sector
• Expand foreign language training in schools
• Promote education abroad programs
• Increase funding for education at all levels

Bottom Line

Brazil is often called ‘o pais do futuro,’ or ‘country of the future.’ South America’s biggest economy has a lot going for it – large domestic market, favourable demographics, expanding middle class. The inflows of immigrants and returning expats are a testament to the country’s increasing allure.

However, Brazil’s talent shortage – even with the brain gain from immigrants and returning expats – could constrain economic growth and disincentivize foreign investment. While the government has made great strides in improving the quality of education, more efforts are needed.

* Trade openness is one of the key measures used in the Global Talent Index to assess relative openness. Brazil has a very large domestic economy so exports make up a relatively small share of GDP (around 10%). Consequently, the country receives a low score on this measure, even though I would categorise its large domestic economy as more of an asset than a liability. Overall, Brazil’s low ranking on openness is much less of a concern than the quality of the labour force.

The fate of the eurozone topped EM investors’ worries at a recent conference. The investors put much higher odds on a eurozone breakup vs. a hard landing in China. Panellists expect Central Europe to be the biggest EM casualty of the euro turmoil. But not all was gloom and doom as a number spoke bullishly about EM corporate debt.

EM Muser: The CEE region is directly in the line of fire of eurozone turmoil given their strong trade and financial linkages. As I noted in a recent post, the banking sector is a particular worrisome source of contagion as Western European parent banks dominate lending in the CEE region via local subsidiaries. Signs of a credit squeeze are already apparent. (See: Is CEE Better Prepared This Time Around?)

As for EM corporate debt, it’s a growing asset class with high yields and many of the issuers are investment grade. However, caution is warranted. According to Fitch Ratings, issuers in Russia and Turkey could face financing problems in a prolonged global downturn given their limited cash cushions. (See: Bloomberg article)

2. India: Fiscal challenges are opportunities
DBS Group Research

The eurozone crisis and global slowdown have come at a bad time for India. The budget deficit has widened relative to 2008, leaving the government with limited room to use fiscal policy to support growth. DBS believes markets have not priced in these fiscal risks. The government has targeted a budget deficit of 4.6% of GDP for FY2011/12, but DBS says it could be as high as 8.5% of GDP.

EM Muser: India’s public debt load has declined in recent years and is below that in most advanced economies. However, at roughly 70% of GDP, it’s still high compared to other EMs – a point I highlighted in a post a while back. (See: Emerging Markets: Fiscal Health Check) 

If the government posts high deficits, it will add to the debt load and could end up weighing on growth and threatening the country’s sovereign credit rating. According to Moody’s, the public debt burden is a major stumbling block that has prevented India from securing an investment-grade rating from the agency.

3. Presentation: Sub-Saharan Africa Outlook
Marion Mühlberger, Deutsche Bank

This presentation provides an upbeat view of Sub-Saharan Africa’s economic prospects and notes the region’s low public debt levels and improved macroeconomic policies.

While Europe remains the region’s most important trading partner, economic ties have grown with Asia, making it the second most important market. The region is very commodity-oriented, but it varies by country. For example, Angola and Nigeria are very oil dependent (90% of more of total exports), while gold is Ghana and Tanzania’s main export.  The presentation does warn investors not to be complacent about political risk.

EM Muser: DB’s hopeful growth outlook for Sub-Saharan Africa is shared by the IMF, in its latest Regional Economic Outlook in October and by the Economist magazine. The cover of the December 2nd issue is titled, ‘Africa Rising.’

Nigeria exemplifies the many risks and opportunities in the region. The democratic election of Goodluck Jonathan in the presidential race earlier this year marked a turning point as it was widely hailed as free and fair. Moreover, the country boasts a large, young population (around 154 million), significant oil  (OPEC’s 6th largest producer) and the region’s second largest stock market behind South Africa. However, many challenges remain – from violence in the north to regional tensions to infrastructure decay – so investors need a strong stomach.

4. 2011 Corruption Perceptions Index
Transparency International

TI released the results of its 2011 Corruption Perceptions Index, covering 183 countries, on December 1st. The usual suspects – i.e. the Nordics – dominated the top 10. Not surprisingly, Somalia and North Korea came in at the bottom of the rankings.

Source: Transparency International

EM Muser: I created the chart above to highlight the scores of a select number of EMs over the last 3 years. If you’re interested in the score of a country not listed, click through to the TI report for the full results. Among the grouping, Russia continues to be perceived as the most corrupt, with Chile the least corrupt.

I find the underlying trends to be as interesting as the rankings themselves. For example, perceived corruption has noticeably improved in Poland over the past three years, while it has steadily worsened in Hungary, South Africa, Colombia and Mexico.

Does it make sense to lump the BRICs together? Not really, says Stephens.

He points out that Brazil, Russia, India and China have little in common other than impressive rates of economic growth. They are not united politically, and he doesn’t see them reliably allying together. Rather, he sees a more multi-polar world where “rising states want to do some things together and some things with the west.”

EM Muser: I completely agree with Stephens that it’s a mistake to view the BRICs as a united political bloc. As the economic power of many emerging markets grows, their political clout will grow as well. However, it should not automatically be assumed they will work together.

We’ve seen a number of recent examples that highlight the lack of coordination among the BRICs. This spring, many EMs would have loved to place one of their own at the helm of the IMF, but they disagreed on who. Overall, it looks like we’re headed toward a more multi-polar geopolitical arrangement – characterized by shifting alliances and no clear dominant power – which likely means a less stable world.

2. South African lawmakers approve ‘secrecy bill’ to protect state
David Smith, Guardian

South Africa’s lower house of parliament passed a controversial ‘Protection of Information’ bill on November 22. The media – as well as human rights organisations, unions and renowned national heroes like Desmond Tutu and Nelson Mandela – see the bill as a major setback for freedom of expression and the fight against corruption.

Daniel Bekele, Africa director of Human Rights Watch: “The manner in which the government pushed this bill through parliament instead of proceeding with consultations as promised, as well as the secrecy embedded in this legislation, send very worrying signs about the government’s commitment to transparency.”

EM Muser: This so-called ‘secrecy’ bill is yet another sign that political risk in South Africa is on the upswing, which is negative for the investment climate. In late October, President Zuma sacked two cabinet ministers for misuse of public funds. Corruption is an ongoing problem, and this bill will make it harder to stamp it out.

The ANC continues to dominate South African politics, winning 66% of the vote in 2009. However, what was once a dynamic party is looking increasingly sclerotic, between allegations of corruption to growing dissension within the party ranks (see The Weekly Mishmash: November 13). Just because the governing party has a large majority in no way ensures a predictable policy environment. Look at Hungary.

3. Not amused: China’s theme park industry should be making easy money
China Economic Review

Over-investment in China is not limited to ghost towns and highways to nowhere. Apparently it also extends to theme parks. Many are boondoggles, and regulators are cracking down. “[T]heme parks larger than 20 hectares or requiring more than US$78 million in investment must obtain national-level approval or halt construction immediately.”

EM Muser: There has been lots of talk about fizzy conditions in China as well as corruption among government officials. The theme park bubble is just the latest example. 

4. Fitch Revises Turkey’s Outlook to Stable; Affirms at ‘BB+’
Fitch Ratings

Fitch held Turkey at one notch below investment grade, but cut the ratings outlook to stable from positive last week. This contrasts with S&P, which upgraded the country’s local currency rating to investment grade in September.

Despite strong government finances and a healthy banking sector, “Turkey’s large external financing requirement leaves it vulnerable to the deterioration in the global outlook,” according to Fitch.

EM Muser: While I am upbeat about Turkey’s medium-to-long term economic prospects, I agree with Fitch that the economy looks vulnerable in the short-term.

As I noted in a recent post, Turkey’s high current account deficit (which Fitch expects to reach almost 10% of GDP in 2011) combined with limited foreign reserves and high amounts of short-term external debt leaves the economy very exposed to a dry-up in external financing. (See Which Emerging Markets Appear Vulnerable? A Look at Early Warning Indicators)

The other ratings agencies still place Hungary on the lowest rung of the investment grade ladder, but I expect that will soon change. The downgrade is no surprise. I’ve dedicated a fair number of posts over the past six months to describing Hungary’s economic and political problems. Some of the links are below:

• Hungary’s Latest Debt Relief Plan: From Bad to Worse
• Hungary’s Vicious Circle: Anemic Lending and Weak Growth
• Hungary: Finally on Investors’ Radar
• Hungary and Turkey: Political Parallels
• Fitch Raises Hungary’s Ratings Outlook: Odd Timing
• The Double Whammy: Debt and Demographics
• Is CEE Better Prepared This Time Around?

Hungary’s last-ditch request for IMF help was too little, too late. As I previously noted, the government publicly trumpeted its interest in a deal before notifying its own central bank – or even the IMF itself – which suggests it was merely a ruse to delay a ratings downgrade. (See my Weekly Mishmash: November 22)

Despite the downgrade, the government does not appear to be coming to its senses. Disturbingly, it seems more out-of-touch than ever based on the Economy Ministry’s latest statement:

“Since the decision by Moody’s has no realistic basis, the Hungarian government can only interpret this as being part of a financial attack against Hungary.” (reported by Zoltan Simon and Abdras Gergely of Bloomberg)

There’s no doubt that eurozone turbulence has compounded Hungary’s already serious economic woes, but the real culprit here is the government and its policies. From the effective nationalisation of private pension assets to its ill-conceived mortgage relief plan, the government has consistently shown disregard for the country’s long-term economic health and an unwillingness to take any responsibility.

According to Bloomberg, the yield on Hungary 10-year yields jumped over 9.5%. This rise in borrowing costs and the slide in the forint will accentuate the country’s economic woes. As one reader aptly commented a few weeks back, Hungary is ‘circling the drain.’  Its significant reserve cushion diminishes the threat of a near-term default. However, the government has large chunks of debt coming due next year (see figure below).

Source: Hungary Government Debt Management Agency (AKK)

Will the government swallow its pride and agree to a condition-laden standby agreement with the IMF? It may, but the country is in need of major structural reforms, and I don’t see the current Fidesz-led government having the political will to implement them.

Jim O’Neill is best known for coining the term BRICs a decade ago, when he predicted Brazil, Russia, India and China would be the world’s future growth drivers. He highlights the critical importance of population dynamics in making his call: “Simply applying the most credible estimates of long-term demographic trends, especially for the working population, is the intellectual cornerstone of the argument for the BRICs’ potential.”

EM Muser: Demographics is an oft-ignored area of economics so it’s interesting to hear O’Neill cite it as a ‘cornerstone’ of his BRIC thesis. I think it’s paramount for long-term investors to look at a country’s population dynamics.

The demographic profiles of EMs vary greatly. Many countries in Eastern Europe have profiles similar to those of advanced economies. This will make it hard for them to avoid the public finance strain, productivity loss and slowing economic growth typically associated with aging populations. However, other EMs are still enjoying a demographic divided given their young and growing populations (eg. Brazil, Indonesia, Turkey).  (See my related post: The Double Whammy: Debt and Demographics)

2.  IMF Is No Cure-All for Hungary
Gergo Racz, WSJ Emerging Europe

Hungary surprised markets when it expressed interest in a new IMF agreement. The announcement marks a sharp U-turn from last year when the government abruptly broke off talks with the lender. Even if an agreement is reached, the post notes that the country’s fundamentals remain poor and its sovereign credit rating still teeters on the edge of ‘junk’.

EM Muser: This appears to be a ploy by the government to delay a sovereign credit rating downgrade. The fact that the government publicly expressed interest in an IMF deal before notifying its own central bank – or even the IMF itself – lends support to this idea.

Hungary wants an deal with no strings attached – that is, with no austerity measures. However, I find it hard to believe the IMF will go along without demanding some sort of structural reforms, which the country badly needs. In the meanwhile, the ploy may work, at least temporarily, as the mere prospect of a deal should help prevent borrowing costs from spiking dramatically. (See my recent posts on the country: Hungary’s Latest Debt Relief Plan: From Bad to Worse and Hungary’s Vicious Circle: Anemic Lending and Weak Growth).

3. Argentina: Balance of Payments Crunch?
Daniel Volberg, Morgan Stanley

Volberg describes the significant fall in Argentina’s international reserves, which have declined by more than $5bn since July. While he does not foresee a full-blown currency crisis, he does note several areas for concern, including the country’s deteriorating balance of payments and an acceleration in investors pulling money out of the country following the tightening of capital controls in late October.

Mr. Volberg believes the government’s currency policy could go one of two ways. The good scenario would involve a rise in interest rates to compensate investors for a weakening of the peso in an effort to keep capital from fleeing, while a bad scenario would feature a more severe tightening in capital controls along with a multiple exchange rate regime.

EM Muser: Argentina poses something of a conundrum. I discussed analysts’ widely varying perspectives on the country’s economic success last week. (See The Weekly Mishmash: November 13). On the positive side, the economy expanded by 7.7% in the year through September. However, this fast growth does not appear sustainable.

It’s increasingly clear that the administration’s policies are draining investor confidence and prompting capital to flee the country. President Cristina Fernandez Kirchner is due to announce her new cabinet in early December, which should give more insight into the government’s future policy direction.

4.  Brazil: ‘Pacification’ of Favelas Not Just a Media Circus
Fabiana Frayssinet, Inter Press Service

Last week, roughly 3000 heavily-armed soldiers and police took over Rio de Janeiro’s largest slum, Rocinha. Officials hailed it as a “recovery of territory” by the state.

The occupation is “part of a new security strategy that provides for a permanent community policing presence as well as services and projects for social improvement and infrastructure in favelas, replacing the traditional policy of head-on warfare on the drug gangs.” According to the article, Rio has some 750 favelas with 1.5 million people, about one-third of the city’s total population. The goal is to occupy 40 of them by 2014.

EM Muser: This is huge positive step forward for Brazil that hasn’t received much international attention. I lived in the country about a decade ago and still remember the power of the drug gangs. These are no common thugs. They have anti-aircraft missiles and were powerful enough to shut down Rio on a number of occasions – a pretty mean feat considering it’s a city of roughly 6 million people. In more recent years, they have managed to shoot down police helicopters.

Drug gangs effectively control large swathes of the city, and it’s encouraging to see authorities finally stepping in. In some ways, their hand has been forced. Brazil is hosting the World Cup in 2014 and the Olympics in 2016. These events represent a coming-out part of sorts for the country, and authorities can’t afford to let Brazil’s image be tainted by public security problems.

5.  Putin is booed at martial arts fight
Charles Clover, FT

The crowd unexpectedly heckled Russian President Vladimir Putin at a live televised fighting event. “Mr Putin was seeking to boost the popularity of the hegemonic United Russia party in forthcoming parliamentary elections on Dec 4, but the spectacle showed that the gulf between the regime and the people appears to be widening.”

EM Muser: This is not the first time one of Putin’s publicity stunts has gone awry. Last month, his spokesman admitted that Putin’s discovery of ancient Greek ceramic pieces on a dive in August had been staged (see here). Despite these stumbles, Putin still enjoys a 61% approval rating according to a recent poll and is expected to return to the presidency in 2012.

Overall, Indonesia has a bright economic future. In the very short-run, investors will pull money out of emerging market assets and stay on the sidelines out of fear, and we’re already seeing this happen (see here).  However, robust emerging markets, like Indonesia, will prove too attractive to resist for long. Similar to the country’s experience in 2008-09, I expect capital outflows to quickly reverse.

Below I detail why Indonesia’s economy is a stand-out among emerging markets and why the economy is well prepared to weather a global downturn.

Indonesia’s Many Attractions

• Robust economic growth

Indonesia’s economy has expanded by an average of  5.7% per year in the 2005-10 period. Even in 2009, when many of the world’s economies contracted, Indonesia’s GDP still grew by an enviable 4.6%, which was significantly higher than the ASEAN-5 average of 1.7%.

Source: IMF World Economic Outlook, September 2011

• Not overly export-dependent

Indonesia is less trade-reliant than its ASEAN peers. Exports amounted to only 25% of GDP last year, compared to 97% in Malaysia and 71% in Thailand. With the biggest population in Southeast Asia, domestic demand is an important growth engine and helps insulate the economy against a sharp contraction in global trade.

Renowned economist Nouriel Roubini is among the country’s cheerleaders: “Some countries in the region are better positioned for long-term, even growth – countries like Indonesia or India, with 50 – 60 per cent of GDP coming from domestic consumption.”

• Upbeat consumers

Consumer confidence is on the slide globally, but Indonesian consumers remain relatively upbeat about their financial situation for next year, making them the third-most confident country in the world, according to a recent Nielsen survey.

Source: Nielsen

• Low debt levels

High debt levels can stunt growth and leave a country vulnerable to a dry-up in financing if their sustainability is in question. Indonesia, however, has refrained from embarking on a leveraging binge. Both the country’s public and external debt burdens are low, even in comparison with other emerging markets. (See my recent post – Which Emerging Markets Appear Vulnerable? A Look at Early Warning Indicators - to get a look at how Indonesia’s external debt burden stacks up against EM peers.)

Source: IMF World Economic Outlook, September 2011

• Abundant natural resources

Indonesia is a leading exporter of both coal and natural gas. Mining and forestry are also important economic activities. Despite illegal logging, the country still has the world’s third largest area of tropical forest, behind only Brazil and the DRC. Indonesia is also a biodiversity hotspot, according to the World Bank, with a diversity of plant and animal species that is almost unparalleled elsewhere in the world.

• Large, young population

Indonesia is home to an estimated 245 million people, and over half are under the age of 30. Young populations tend to consume more and exert less pressure on public finances (eg. lower pension burdens and lower healthcare spending). Indonesia is set to continue benefiting from this demographic dividend in coming years. According to the UN, the working-age population will rise to 70% of the total by 2025.

Source: UN World Population Prospects

• Relatively stable political conditions

The first democratic elections in the post-Suharto period took place in 1999, and Indonesia became the world’s third largest democracy. Under the leadership of President Susilo Bambang Yudhoyono, the country is politically stable. His public approval rating stands at an enviable 46.2%, according to a recent survey. Meanwhile, the threat of separatist violence in northern Aceh province receded following a peace accord signed with the Free Aceh movement in 2005. Corruption, however, remains a serious issue.

• Healthy banking sector

Indonesia has one of the best capitalised banking systems in the world. Stress tests indicate that even in an extreme scenario, involving defaults in the US and Europe, the banking sector’s capital adequacy ratio will remain above 15%, according to the Bank of Indonesia’s latest financial stability report.

Meanwhile, with an average loan-to-deposit ratio of 82%, Indonesian banks are not reliant on volatile external funding to finance lending growth. This contrasts with countries like Hungary, South Korea or Brazil where ratios are in excess of 100%. While Indonesian banks enjoy high profitability, some deterioration in asset quality is expected in coming quarters.

Source: Fitch Ratings

• Smart policymaking

The central bank has taken a number of measures to stem hot money inflows into state debt securities. As of May 13, Bank of Indonesia (BOI) extended the minimum holding period of its bank certificates, SBIs, from one month to six months. This was a smart move that makes Indonesia somewhat less vulnerable to a large capital flow reversal.

Meanwhile, policymakers have amassed a large cache of international reserves, enabling the BOI to credibly back up its pledge to intervene and smooth exchange rate volatility. As a result, Indonesia is less likely to experience huge capital outflows. That is because the BOI’s pledge should minimise foreign investors’ concern that a sharp slide in the rupiah will wipe out their gains. (See the excellent piece by Deyi Tan and Seen Meng Chew of Morgan Stanley that discusses the structural improvement in Indonesia’s currency volatility). As seen in the graph below, the rupiah is showing much more stability against the USD and euro relative to 2008-09.

Source: Oanda

The BOI has cut rates twice, and the policy rate now stands at 6%. While this monetary loosening was controversial, I believe the BOI is ahead of the curve, as these cuts will help cushion the blow of the global slowdown on Indonesia’s domestic economy.

Still Not the Time to Sit Back and Relax

Despite policymaker efforts, capital outflows remain a clear and present danger. Foreign ownership of tradeable government securities is relatively high, at 33% as of June 2011. This is a sign of market confidence in Indonesia, but it also makes the economy vulnerable to outflows during times of global financial stress like now.

Such outflows occurred at the height of the global financial crisis in Q4 2008 and occurred once again in Q3 2011 as seen in the graph below. Nevertheless, the outflows in Q4 2008 quickly reversed, and we expect the outflows in Q3 2011 to be temporary as well.

*Estimate

Source: Bank of Indonesia

Bottom Line

Indonesia has come a long way since the Asian crisis in the late 1990s. Despite the storm clouds on the horizon, Southeast Asia’s biggest economy looks on course to be a star performer in coming years. Structural improvements have enhanced the economy’s resilience, and a reversal in capital flows is no longer a showstopper.