Tag Archives: China

Peru: Riding China’s Coattails

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Peru has emerged as a star performer in Latin America. The economy is on a tear, expanding by an average of over 7% per year since 2006. In comparison, the region as a whole grew by an annual average of only 4% per year. Peru even managed to eke out positive growth in 2009 during the global financial crisis.

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 Weekly Mishmash: November 29

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1. A story of Brics without mortar
Philip Stephens, FT

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 Weekly Mishmash: November 13

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1. Commerzbank: a chill wind for CEE

Stefan Wagstyl, FT Beyond Brics

Commerzbank, Germany’s second-largest, is in the midst of deleveraging in response to the EU-wide imposition of stricter capital requirements. Central & Eastern Europe (CEE) is in the firing line. The bank has said that it will temporarily suspend new lending outside its core markets of Germany and Poland.

EM Muser: I warned about the potential for a credit squeeze in the CEE in a recent post and it’s now moving from possibility to actuality (See: Is CEE Better Prepared This Time Around?) Western European banks dominate the CEE banking sector via subsidiaries. Most will not fully withdraw, but many will scale back support for their subsidiaries (out of precaution or necessity).

The Commerzbank announcement shows this trend is already underway. However, in and of itself, the announcement won’t have much of an effect. The bank’s exposure to the CEE region was just under just under €21bn in 2010, and this was mostly to Poland where it will continue to extend new loans.

2. Argentina’s president irks U.S. pundits

Paul Katz, Salon.com

President Cristina Fernandez is popular domestically and recently won reelection by a wide margin, but she remains a controversial figure in the international media.

Katz provides an unusually balanced picture of Argentina’s administration. He acknowledges the government’s manipulation of official inflation statistics and its intolerance of criticism, but also points out that the economy is roaring. GDP has expanded by an average of over 5% annually since 2007. Meanwhile, unemployment has fallen by half since 2003, and income inequality has narrowed.

EM Muser: Mark Weisbrot of the Center for Economic and Policy Research argues that Argentina is actually a success story that provides important lessons for the weaker euro zone economies given its rapid recovery in output and employment following its 2001 default (See: The Argentine Success Story and Its Implications).

Weisbrot’s view contrasts with the many articles that focus on Argentina’s lack of access to international capital markets and paint a pretty bleak picture of the country’s economic future (see the FT). They note that capital is flowing out of the country and foresee a sharp slowdown in economic growth.

The naysayers chalk the country’s robust economic growth up to good fortune (high commodity prices and the robust performances of the country’s trade partners). Meanwhile, Weisbrot credits the government’s unconventional economic policies. In my view, the jury is still out. Argentina’s resilience in the face of the global downturn will prove telling. While no economy is likely to remain untouched by the downturn, those economies that are healthy and well-run are likely to recover the fastest. Will Argentina be among them?

3. South African Credit Rating Outlook Cut by Moody’s on High Political Risk

Andres R. Martinez, Bloomberg

Moody’s cut the outlook on South Africa’s credit rating to negative in a move that surprised analysts. The rating currently stands at A3, four notches above investment grade. The ratings agency is concerned that factionalism within the ruling ANC party will erode the government’s commitment to responsible fiscal policies.

EM Muser: Shortly after Moody’s announcement on Nov 9th, the ANC expelled Julius Malema, the leader of its youth wing, from the party. He has called for the nationalisation of mines, raising concerns among investors. It’s unclear whether his departure is a done deal and whether this will reduce political risk as Malema may still contest the ruling.

4.  Don’t panic, China’s economy is not on the rocks yet

Michael Pettis, FT op-ed

Amid the recent bearish commentary on China, Pettis provides a reality check. While he acknowledges that there are tough times ahead for China as it attempts to move its economy toward a more consumption-led growth model, he does not see a banking crisis on the horizon.

“Beijing effectively guarantees the profitability and stability of the banking system by socialising credit risk and enforcing a high spread between the lending and deposit rates. As long as the government is credible, the banks will be solvent.”

EM Muser: Pettis’ argument makes a lot of sense to me. Unlike other countries (Iceland and Ireland, for example), the Chinese government has the resources to effectively backstop its banks. In October, the government’s investment fund moved to shore up the shares of four major state-owned banks, showing its commitment to stabilising its banking system (see here).

While China looks set to avert a banking crisis, the economy still looks headed for a slowdown, as Pettis acknowledges. The question is whether it will be a hard or soft landing. (See my post: IMF’s Latest Growth Forecasts for China Look Overly Rosy)

5. Hungary to Get Tighter Grip on Municipal Finances

Gergo Racz, WSJ Real Time Emerging Europe

“Hungary’s government approved a law that would substantially revise the operation of the local government system by reshuffling jurisdictions and keeping a tighter central watch on how much municipalities spend.”

EM Muser: Good economic news out of Hungary is few and far between. While this legislation is a positive step, it’s too little too late. Last week, Fitch slashed the outlook on the country’s sovereign credit rating to negative, while S&P placed Hungary on CreditWatch with negative implications. A downgrade by any of the three would push Hungary’s credit rating to ‘junk’. (See my earlier posts: Hungary: Finally on Investors’ Radar and Fitch Raises Hungary’s Outlook to Positive: Odd Timing)

The Weekly Mishmash: November 2

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1. Regional Economic Prospects: October 2011

European Bank for Reconstruction and Development (EBRD)

Economic fundamentals in emerging Europe are generally better than before the onset of the crisis and the EBRD does not expect another region-wide recession. But it also believes the region now faces greater downside risks.

“[E]xternal shocks may be more severe than in 2008/09 on account of higher stress in the euro zone, including the banking systems, particularly under the downside scenario. There is a risk that the ability of bank groups to pass on support to their subsidiaries in the transition region may be constrained by their national governments. This could result in a substantial reversal of bank debt flows and a large contraction of credit in the region, with potentially severe consequences for output.”

EM Muser: Similar to my recent post (Is the CEE Better Prepared This Time Around?), the EBRD questions whether CEE countries will prove more resilient this time around and hones in on the potential for a severe disruption in cross-border banking flows.

The EBRD advises increased policy coordination along the lines of the Vienna Initiative in 2009, when Western European parent banks collectively pledged to maintain their exposure to the region’s hardest hit countries. The Vienna Initiative was a novel idea that pulled the region back from the brink of a full-fledged crisis. However, such an initiative could prove more difficult to implement this time around given the heightened stress on Western European banks stemming from the eurozone debt crisis.

2. The Past, the People and the Policies

Spyros Andreopoulos, Morgan Stanley

The author examines the forces that have shaped the thinking of today’s central bankers. He notes that the most prominent – Ben Bernanke (US), Adam Posen (UK), Athanasios Orphanides (ECB) – have spent a large amount of time studying ‘depression economics’ – eg. the Great Depression and Japan’s more recent slump. As a result, they believe in avoiding deflation at all costs and in avoiding premature tightening that could tip the economy back into recession.

Andreopoulos notes that this line of thinking comes with certain risks: “In particular, erring on the side of caution likely implies exiting too late, which in turn means elevated medium-term inflation risks. Yet, it is rational for a risk-averse central bank to prefer the lesser of two evils…”

EM Muser: Andreopoulos focuses on advanced economies, but his points are also useful in understanding recent actions of emerging market central banks. Like advanced economies, they face a delicate balancing act.

As the global backdrop darkens, EM central bankers understandably want to cushion the blow on their economies. And since monetary policy works with a lag, several (eg. Brazil, Indonesia, Israel and Turkey) decided to preemptively cut their policy rates, surprising many analysts. (See my post: Giving Turkey’s Central Bank the Benefit of the Doubt). Notably, Turkey has since backtracked and raised its lending rate on Oct 20 due to a sharp depreciation in the lira.

As with advanced economies, cutting rates is a gamble as it raises inflation risks down the line, especially for EM central banks that have fought hard to gain credibility. However, for many, this is the lesser of two evils given the threat of a new global recession.

3. China labour costs soar as wages rise 22%

Simon Rabinovitch, FT

Official data showed minimum wages in the world’s most populous country rose by an average of 22% this year. Labour costs are starting to rival those in other emerging markets, and Vietnam and Bangladesh are among the beneficiaries that are luring low-cost manufacturers and winning market share.

EM Muser: The jump in minimum wages relates to government efforts to calm social tensions and stimulate domestic consumption. However, the rise may backfire as the Economist magazine reports that some businesses, short of cash, are simply not paying their workers. (See: Unpaid wages in China: Can’t pay, won’t pay).

China will continue to offer relatively cheap labour for now, but questions are growing about how long it will last given the country’s demographics. According to UN data, China will add roughly 18 million people to its working-age population in 2011-20, which is paltry compared to the 114 million people added over the past decade.

4. Brics split on euro zone rescue

Carolyn Cohn, Reuters

Emerging markets aren’t going to be the white knights for the eurozone that many had hoped. India and Russia, in particular, are wary of investing in the European Financial Stability Facility (EFSF), although they may still extend financial support through the IMF.

EM Muser: This should not come as a surprise. First, it would be very hard for BRIC leaders to sell their populations on the need for a European bailout when their per-capita incomes are so far below the euro area average.

Second, the big emerging markets have not coordinated well on the international stage, which makes it unlikely the BRICs could successfully reach a joint agreement on a bailout plan. For example, Brazil’s finance minister Guido Mantega let slip in September that a BRIC rescue of the eurozone was a possibility. However, he had failed to consult with the other BRICs before his pronouncement.

The BRICs could exert more influence if they presented a more united front. For example, this spring, many EMs would have loved to place one of their own as head of the IMF. However, they disagreed on who. Europe and the US were better coordinated and managed to stick Christine Lagarde in the top spot. (See my related post: Why Emerging Markets Are Not in the Running for Top IMF Job)

The Weekly Mishmash: October 9

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1.  Why China won’t conquer the world

By Xué Xinran, Telegraph

Ms. Xinran provides a personal account of the growth challenges facing China. She’s a Chinese expat who describes the frenetic pace of life in her homeland and goes on to criticize the education system, saying it ‘stifles rather than encourages creativity,’ an important ingredient for entrepreneurship. She agrees with Larry Hsien Ping Lang, a finance professor at the University of Hong Kong, who fears that China’s ‘bubble economy’ is on the verge of bursting. They believe China’s economy must slow down to give time for its education system and society to catch up.

EM Muser: This article adds to recent commentary (see Patrick Chovanec and Jim Walker) that chips away at the image of China as an unassailable economic giant. While it’s unclear to me how much China will slow and the exact timing, growth forecasts showing Chinese growth continuing at over 9% on an annual basis in coming years look way too optimistic. (See my recent post: IMF’s Latest Growth Forecasts for China Look Overly Rosy)

2. Megatrends for Investors

By Dr. Shane Oliver, AMP Capital

Dr. Oliver  points to strong commodity prices as a key long-term investment trend. “After a 25-year bear market into the end of the last century, commodities are now just over a decade into a secular bull market driven by strong structural demand on the back of industrialisation in China and other emerging countries, all at a time of still- constrained supply. notwithstanding cyclical fluctuations, the longer-term trend in commodity prices is likely to remain strong, possibly accentuated by a continuing long-term downswing in the US dollar and other major advanced country currencies.”

EM Muser: I share a similar view to Dr. Oliver. A growing world population, combined with greater challenges in producing commodities (due to scarcity or climate change in the case of agriculture), make me a believer in the medium- to long-term commodities story. But I think commodity prices will fall in the near-term, particularly given slowing demand from advanced economies.

3. Hungary’s new path is the hidden danger to Europe

By Ian Bremmer, FT

The president of the Eurasia Group writes a scathing critique of Hungary’s political direction in his latest FT op-ed and asserts that the government’s efforts to wear away the country’s democratic institutions have the potential to taint the EU’s image. “The Fidesz government has leveraged its ability to warp the constitution, cementing institutional and democratic rollbacks into the rule of law. Mr Orban’s consolidation of power at the expense of democratic institutions exposes a fundamental challenge for the EU as a whole – it cannot enforce the very credo that spawned it. Hungary’s disregard for democracy and civil liberties could threaten the European brand in the eyes of potential new members and the world at large.”

EM Muser: I agree with Bremmer and have a written a number of posts on Hungary’s underlying political and economic problems. (See Hungary and Turkey: Political Parallels, Hungary’s Latest Debt Relief Plan: From Bad to Worse, Hungary’s Vicious Circle: Anemic Lending and Weak Growth, Fitch Raises Hungary’s Ratings Outlook: Odd Timing). I find Hungary’s ongoing swing away from democracy particularly unnerving considering how unnoticed it has been by the international community.

4. Colombia: Ready for the Worst

By Daniel Volberg, Morgan Stanley

Mr. Volberg  lays out two key reasons why Colombia’s economy is in relatively good shape to face global headwinds: 1) solid balance sheet (strong international reserve cushion, a modest current account deficit, and access to the IMF’s flexible credit line), and 2) significant room for monetary and fiscal stimulus.

EM Muser: This piece is short and to the point. I looked at Colombia’s economy in a recent blog post and came to similar conclusions as Mr Volberg. In addition to the excellent arguments that Volberg makes, I believe Colombia’s strong domestic demand orientation and its resilience during the height of the global financial crisis in 2008-09 also provide room for comfort. (See: How Exposed is Colombia to a China Slowdown.)

How Exposed is Colombia to a China Slowdown?

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Nervousness about a China slowdown is growing. Patrick Chovanec, an economics professor at Tsinghua University, points to mounting evidence “that the fabric of China’s investment-led growth is starting to fray and unravel.”  Clearly this is not good news for the global economy, but which emerging market economies are in the direct line of fire?

South America looks quite vulnerable. China has overtaken the US as Argentina, Brazil and Chile’s top trade partner. Meanwhile, the Chinese have invested heavily in the resource-rich continent. (See Politico article: China Picks up Slack in U.S. Trade).

Regular reader Dulan has asked specifically about Colombia’s vulnerability to a China slowdown so let’s take a look.

Minimal direct exposure to China

In contrast with others in the region, Colombia remains firmly in the US orbit and does not have significant trade or investment ties to China.

Figure 1: China doesn’t rank among Colombia’s top trade partners

Source: DANE

Figure 2: Chinese direct investment in Colombia is small, particularly in comparison with Brazil

 

Source: ECLAC (Foreign Direct Investment in Latin America and the Caribbean)

Still indirectly exposed

If China loses steam, there will be global ripple effects and Colombia will not be immune. China is the second largest economy in the world and its share of global GDP reached almost 14% on a PPP basis in 2010. The IMF estimates that the impact of Chinese demand on the world’s largest economies has more than doubled over the past decade. A deteriorating outlook for Chinese imports could send commodity prices plummeting.

Oil and coal dominate Colombia’s exports, and a downturn in China will likely lead to a cutback in global energy demand. Oil prices are already on the decline, with the price of Brent crude falling below $100 per barrel this week for the first time in over 6 months.

Figure 4: Coal and oil together accounted for over half of Colombia’s total exports in 2010

 

Source: DANE 

Trade and investment ties with the US remain strong. Colombia is the third largest exporter of oil to the country, and US investors account for the bulk of Colombia’s FDI. So the bigger worry for Colombia, in relation to a China slowdown, is how much an impact it has on the US, which is already battling high unemployment and stagnating growth.

Figure 5: The US accounts for over a third of Colombia’s total FDI

 

Source: Banco de la Republica de Colombia

Good news

The good news is that Colombia’s economy is very domestic demand-oriented, with exports accounting for just 16% of GDP in 2010, which should provide some degree of insulation from global turbulence. The fact that Colombia’s banking system is healthy, with one of the highest capital adequacy ratios in the region (at 17.9% in April 2011), should also serve as a shock absorber.

Latin America as a whole contracted by 1.9% in 2009 at the height of the global financial crisis. Colombia was one of the few economies in the region that expanded on an annual basis, growing by 1.4%, which highlights its relative resilience in the face of global turmoil.

In sum, Colombia is less vulnerable to a China slowdown compared with other South American economies.

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.”

Forex Reserve Diversification: Is Mauritius a Trendsetter?

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Emerging market countries hold the lion’s share of the world’s foreign exchange reserves. China is far and away the biggest holder with roughly US$3.2 trillion, or roughly 30% of the world’s total. As seen in Figure 1 below, the bulk of the world’s reserve stockpile is held in US dollars and euros.

As the eurozone is now battling for survival and the US’ safe haven status begins to tarnish, will emerging markets finally take action and diversify their forex reserves? Well, Mauritius looks ready to do so. Is this the start of a broader trend?

Figure 1: Almost all the world’s forex reserves are in US dollars or euros

Source: BIS, IMF, U.S. Treasury, Ashmore (Here’s the link).

*as of September 2010

In early August, the Mauritian central bank governor Rundheersing Bheenick said: “We are busy looking at the possibility of buying Chinese bonds, also South African and Indian bonds just to diversify away from too much dependence on the well-known euro and dollar currencies.”

The Mauritian central bank has already diversified its reserves into new commodity currencies such as Canadian, Australian and New Zealand dollars, as well as the Norwegian kroner. Nevertheless, given the small size of Mauritius’ reserve holdings (roughly US$2.9 bn), their diversification is unlikely to have much more than a symbolic impact.

The key question remains….will the big emerging market powerhouses follow suit? The short answer is no, at least not in the near-term.

Yes, the US and eurozone look increasingly wobbly, and the global economy is certainly becoming more multipolar as emerging markets’ clout grows. Yet, EM central banks – at least the big ones – are not ready to diversify their forex reserves in any significant way for at least two reasons.

1) The simple fact is that there’s no real alternative to the US dollar and euro (particularly for the big emerging markets with large reserve stockpiles to manage) given their unparalleled liquidity, and many central bankers seem resigned to this fact.

After S&P cut the US credit rating earlier this month, Russia’s Deputy Finance Minister Sergei Storchak was quick to say there were no plans to restructure the country’s reserves, noting that the US debt markets are still among the most liquid and reliable. Russia is the world’s 3rd largest holder of forex reserves.

2) The other major reason that large reserve stockpilers, such as China, have their hands tied on diversification is their desire to hold down the value of their own currencies against those of their big export markets – the US and eurozone – in order to keep their exports competitive.

China has talked a good game about forex reserve diversification, but it appears to be nothing more than lip service. Analysts estimate roughly 70% of the country’s reserves are in US dollar assets. See this blog post from Michael Pettis on why China won’t sell US bonds anytime soon. Basically, it boils down to the fact that the following two policy goals – greater forex reserve diversification and maintaining a currency peg – are pretty much mutually exclusive.

So far, policymakers – particularly in Asia – have chosen to keep their de facto currency pegs in place and this looks unlikely to change in the near-term.

Local Government Woes: Next Leg of the Crisis?

Posted on by emmuser
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The global economy has returned to growth, but that doesn’t mean the crisis is in the rearview mirror.  A major legacy of the first stage of the crisis is the scar left on public finances. Public debt burdens in both emerging markets and advanced economies have soared in recent years, and they have already reached a boiling point in the euro zone periphery. Mark Horton of the IMF explores the reasons behind the fast build-up in public debt in the paper Fiscal Policy Issues after the Crisis.

Governments worldwide are now in belt-tightening mode. However, financial troubles at the local government level could undermine such efforts. More importantly, defaults by local governments could slow economic growth and/or threaten financial stability. Adding to the uncertainty, local government finances tend to be harder to track than those of central governments, but they are still important for gauging a country’s overall economic health.

Case of the United States

Local governments, like the federal government, suffered a contraction in tax revenue during the recession, and they are now having trouble slashing services fast enough to keep pace with the fall in revenue. This has led to wider budget deficits and higher debt levels. A major concern is that states – those most in trouble include California, New Jersey, Ohio – will cut aid to local governments.

A dangerous snowball effect could develop, whereby rising debt levels induce higher borrowing costs, which in turn makes it more challenging for local governments to service their debt. Inadequately funded pension liabilities are adding to their woes. Rather than raising taxes and irking voters, local governments may instead opt to default. So far, no major city has done so, but there are fears that this could soon change.

How worried should we be? Meredith Whitney, a prominent analyst known for looking beyond the Wall Street consensus, has predicted that dozens of US cities will default on their muni bonds. “Next to housing this is the single most important issue in the US and certainly the biggest threat to the US economy,” she said in a recent interview. Warren Buffett, the oracle of Omaha, has joined Ms. Whitney in expressing concern. See here.

Others say such fears are overblown. See Larry Swedroe of CBS MoneyWatch. Much of his counterpoint to Meredith Whitney seems to rely on looking at past defaults and extrapolating what happened to the future (eg. in previous defaults in Orange County and NYC, bondholders were made whole so they will be this time around too), which doesn’t seem like a particularly strong argument. Bloomberg columnist Joe Mysak also goes on the offensive against Whitney. Most of the column seems to be unsubstantiated vitriol against Whitney, except for the quotes he took from a Fitch report. “Debt service is generally less than 10 percent of a state or local government’s budget, and in many cases much less…. so not paying it does not do much to solve fiscal problems (particularly as compared to the costs of such an action).”

In response to fears of default, there were large net outflows from muni bond funds in late 2010/early 2011, as seen in the graph above. According to estimates from the Investment Company Institute, inflows returned to positive territory in May. Some have taken this as a sign that all’s well with muni bonds, but that remains to be seen.

Case of Hungary

The United States is not an isolated case. Financial troubles at the local level are one of the obstacles facing Hungary as it attempts to bolster public finances. Cutbacks by the central government have added to local governments’ fiscal burden. Hungary missed meeting its general government budget deficit target of 3.8% of GDP in 2010 owing to a higher-than-expected deficit at the local government level.  By end-2010, local governments had accumulated debt amounting to over 5% of GDP.


Local government debt accounts for only a small share of Hungary’s total public debt, which topped 80% of GDP in 2010. However, it has some dangerous, potentially systemic implications. In the latest Financial Stability report, Hungary’s central bank warned that local government debt poses a risk not only to public finances, but to the health of the banking system as well.

By the end of 2010, banks’ exposure to municipalities exceeded HUF 1,000 billion (EUR3.7bn, US$5.4bn), accounting for 5% of total bank loans.  As the central bank notes, “Credit risks are further aggravated by the fact that a large portion of municipality bonds were issued with a few years grace period, during which the borrower pays interest only, without servicing the principal. Once the grace periods expire, monthly installment burdens increase which, according to our estimates, may increase the expenditures of local governments by up to HUF 25-30 billion at the system level in the coming years.”  The fact that 60% of local government debt (bonds and loans) is foreign currency-denominated (mostly Swiss francs) has added to solvency concerns.

In Hungary, there is not much data on local governments’ fiscal situations, which makes it challenging to evaluate. This is the case in many countries.

Case of China

Even before the global financial crisis, analysts worried that debt-laden local governments in China, if allowed to default, posed a risk to macroeconomic and financial stability. See this blog post from World Bank economist Louis Kuijs which details the issue: China’s local government debt—what is the problem?

A recent news report from Reuters suggests regulators are finally moving to address the problem. The central government is reportedly set to pay off some of local government loans, but banks would also take part of the hit. However, China expert Michael Pettis says that while it’s good that authorities are recognising and quantifying the problem, it doesn’t address who will ultimately foot the bill for the losses.