Tag Archives: Indonesia

The Weekly Mishmash: December 14

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1.  EM: Who is vulnerable?
Markus Jäger, Deutsche Bank

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.)

Indonesia: Ugly Duckling No More

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The Indonesian economy has transformed from an ugly duckling in the late 1990s into something of a swan today.  No economy in the world will prove fully immune to fallout from the eurozone debt crisis, and Indonesia is no exception. Nevertheless, Southeast Asia’s biggest economy has a lot going for it, from a young population to low debt levels to a balanced growth model that is not overly export-dependent. Not only are Indonesia’s economic fundamentals stronger than Western economies like the U.S. and Europe, they’re also in better shape than most other emerging markets.

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.

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 24

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1. Internationalization of Emerging Market Currencies–A Balance between Risks and Rewards

By Samar Maziad, Pascal Farahmand, Shengzu Wang, Stephanie Segal, and Faisal Ahmed, IMF

This paper points to signs that a ‘slow but steady increase’ in the use of emerging market currencies in international transactions is underway. Nevertheless, the US dollar and euro continue to overwhelmingly dominate.

“Key EM currencies with potential for internationalization are the Brazilian real, Chinese renminbi, Indian rupee, Russian ruble, and South African rand. All these economies have significant regional importance and economic weight.” They conclude that, going forward, “it seems likely—if not inevitable—that emerging market currencies will account for a larger share of international reserves.”

EM Muser: Greater international use of EM currencies is a very slow-moving trend. But we’re living in an increasingly multipolar world, and movement toward a multi-currency system reflects this. Notably, not all EM currencies exhibit the economic size and financial depth to achieve internationalisation, but as noted above, a fair number do. (See my related posts: Forex Reserve Diversification: Is Mauritius a Trendsetter? and EM Currencies: Same Same But Different)

2. Hungary mulls porn tax to fund film biz

By John Nadler

The Hungarian government’s latest creative financing proposal,  put forward by MP Laszlo Simon, involves slapping a new tax on the porn industry to subsidize locally produced films.

EM Muser: Creative is one adjective I would use to describe Hungary’s government, although I can think of a number of less pleasant adjectives as well. In truth, a porn tax is probably not be a bad idea…nothing like a good vice tax to raise some revenue without losing popular support. However, I find parliament’s interest in this trivial issue at a time when government finances are rapidly deteriorating to be disturbing.

Hungary is walking a tightrope as its debt rating teeters on the verge of ‘junk’ status – a one-notch downgrade from any of the three major ratings agencies would do it. Yet, MPs seem to think now’s the time to advance their pet causes rather than implement real reform. Not a good sign. (See my related posts: Hungary’s Vicious Circle: Anemic Lending and Weak Growth and Hungary’s Latest Debt Relief Plan: From Bad to Worse)

3. Strong Domestic Demand Cushions Indonesia from Global Uncertainty

By the IMF Survey Magazine

The IMF sees relatively clear skies ahead for Indonesia, making it a bright spot in an increasingly gloomy global outlook.

“The outlook is very robust. In the near term we expect Indonesia to continue to grow above 6 percent both in 2011 and in 2012. We say this despite the global volatility we see because the domestic foundation of economic growth in Indonesia is so strong. We see strong credit growth, and despite lower growth in the rest of the world, we think that Indonesia is still going to grow at a strong rate.”

EM Muser: The consensus is that Indonesia is likely to show considerable resilience in the face of global market turmoil. This coincides with my own findings  (See related post: Which Emerging Markets Appear Vulnerable? A Look at Early Warning Indicators) and with what analysts Devi Tan and Seen Meng Chew at Morgan Stanley have also concluded. 

4. A Flat World Will Take a Long Time to Smooth Itself Out

By Pankaj Ghemawat, Bloomberg

Ghemawat notes that most people overrate the degree of cross border integration and he throws out some great statistics to illustrate his point and provide food for thought.

Did you know that only 3% of the world’s people actually live outside the country in which they were born, and only 2% of university students study outside their homelands? Or that only 2% of telephone calls are international, and less than 18% of Internet traffic crosses national borders? He also points out that FDI makes up a paltry 9% of all fixed investment globally.

EM Muser: There has been a lot of focus on the process of globalisation over the past few years, and a general assumption that the pace is fast and furious. I love this piece because Ghemawat provides a reality check and argues that we’re still really not all that integrated. It reminds me that it’s always a good idea to question and evaluate our assumptions.

Which Emerging Markets Appear Vulnerable? A Look at Early Warning Indicators

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All eyes are now on the eurozone debt crisis. However, we know from past experience that problems in advanced economies can spill over to the rest of the world with dangerous consequences. Emerging markets are not immune. The IMF Director Paulo Nogueira Batista Jr recently expressed concern that capital could flee Brazil if the eurozone debt crisis intensifies, and his concern is not unfounded.

As seen in 2008-09, global risk appetite dried up and prompted large capital outflows out of many emerging markets, particularly in Eastern Europe. As a result, certain economies found themselves teetering on the edge of crisis. Latvia, Hungary and Romania were among those who turned to the IMF for help.

These Eastern European economies showed vulnerabilities before the onset of the global financial crisis, as exhibited by high current account deficits and heavy external debt service obligations. However, it took an external shock to bring these vulnerabilities into the spotlight.

So which EM economies look vulnerable in the event of another sudden stop in capital flows?

Below I look at a cross-section of emerging markets and compare their relative vulnerability to a sharp slowdown in capital inflows. (Note: the set of EMs was chosen largely based on data availability).

There is no defined set of early warning indicators that perfectly predicts which countries are at risk of a crisis, but some have stronger predictive power than others. Jeffrey Frankel and George Saravelos conducted a sweeping literature review to find the most consistent leading indicators of crisis. (See: Reserves and other early warning indicators work in crisis after all)

Measures of international reserves and the real exchange rate stand out as the best tools to assess a country’s vulnerability. Their findings suggest the current account balance is also a good indicator to monitor.

Figure 1: Adequacy of international reserves

Source: IMF, national central banks, author’s calculations

*Stock of external debt as of June 2011, **GDP based on IMF’s latest 2011 forecast

International reserves provide a certain degree of insurance against capital flow volatility. Among the EMs surveyed, Russia and India stand out for their relatively large caches of international reserves, while Turkey ranks near the bottom of the pack, both as a % of external debt and % of GDP, which is a source of vulnerability. Blogger Emre Deliveli, as well as journalist Taylan Bilgic, questioned the adequacy of Turkey’s reserves in a recent column.

The ratio of short-term debt to reserves is a particularly good measure for assessing vulnerability. The lower the ratio, the better. Unfortunately, not all countries provide data on short-term debt, but a few do. For example, India’s ratio is 21%, well below Turkey’s ratio of roughly 86%.

This measure, like the others, needs to be taken with a grain of salt. A country may have a large chunk of debt coming due within the next year, but may have very strong macro fundamentals, making repayment problems highly unlikely. So it’s always necessary to consider the context. In any case, Turkey also looks vulnerable on this measure.

Figure 2: Divergence of Real Effective Exchange Rate from Trend

Source: BIS, author’s calculations

The probability of a currency crisis increases when the real exchange rate is overvalued relative to trend. However, this needs to be taken with a grain of salt as well. For example, many Asian currencies showed no significant appreciation in the late 1990s, yet these economies still descended into crisis.

On this measure, the Brazilian real and Indonesian rupiah currently show the most overvaluation relative to trend. In contrast, Turkey looks to be the least vulnerable on this measure.

Figure 3: Current account balance

Source: IMF WEO Database, September 2011

Large current account deficits also increase the probability of crisis and indicate that a country is borrowing more than it’s saving. All recent financial crises (eg. the Asian Crisis, Argentina in 2000, Brazil in 2002) featured current account deficits, with the exception of Russia in 1997. A current account deficit is not necessarily a bad thing if it is financing activities that are enhancing the country’s productive capacity. However, a deficit can quickly become unsustainable if a country is unable to secure the necessary external financing to fund it.

On this measure, Turkey – and to a lesser degree, Poland – look potentially vulnerable.

Conclusion

A look at early warning indicators suggests that Turkey is vulnerable to a sudden stop in capital flows based on its relatively low level of reserves and high current account deficit. Poland also looks vulnerable – albeit less so than Turkey. However, as I note above, these measures need to be taken with a hefty grain of salt. They’re useful in figuring out where a countries’ vulnerabilities may lie, but further investigation is necessary to understand the context.

The Weekly Mishmash: October 16

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1. Brazil’s states in ‘tax war’ to win iPad production

By Joe Leahy, FT

The state of Manaus, in the Amazon basin, is facing stiff competition from other Brazilian states for a massive technology project to produce iPads.

“[T]oday Manaus is fighting for its life. The city is vying to secure one of the biggest technology projects Brazil has ever seen – a $12bn plan to produce iPads. But more powerful states, particularly São Paulo, Brazil’s wealthiest and most industrialised, are trying to win the project by offering tax breaks of their own – benefits that Manaus claims are illegal under the constitution and could fatally erode the tax advantages of manufacturing in the Amazon.”

EM Muser: Tax wars are not isolated to state governments. This is also a trend seen at the global level as national governments compete against each other, offering huge tax breaks in a bid to win foreign investment. I believe that this is one of the reasons, among many, behind the public debt crises we’re now witnessing in advanced economies.

Large companies are often able to pit governments against each other in a bid to sweeten their tax breaks. This results in a ‘race to the bottom’ that favours multinational companies at the expense of states, which suffer from reduced fiscal revenue. The only real way to end such bidding wars is through some kind of cross-country tax harmonisation, which looks unlikely anytime soon.

2. Indonesia: Pre-emptive Rate Cut In Anticipation Of Global Downturn

By Ho Woei Chen, United Overseas Bank

Indonesia’s central bank surprised markets by cutting its benchmark interest rate by 25bp, bringing it back to 6.5%, the record low reached during the global financial crisis. UOB’s Chen sees the central bank move as risky.

“We see the interest rate cut slightly premature at this point given that domestic growth has remained resilient…The rate cut which was targeted at supporting growth could increase capital outflow risk in the environment of global uncertainties. We have seen foreigners paring their holdings of the Indonesian government bonds down to 31.3% of total outstanding in September from 35.1% in August.”

EM Muser: Indonesia has joined Brazil and Turkey, the first major EMs to cut rates preemptively amid increasing signs of a major global slowdown. Brazil and Turkey’s decisions came under heavy criticism, as has Indonesia’s. However, the latest Emerging Markets Purchasing Managers’ Index, compiled by Markit/HSBC and released on Oct 12th, provides yet another confirmation that a slowdown is underway.”Emerging market manufacturing output fell in Q3, bringing to a close nine successive quarters of growth.”

I believe these central banks are ahead of the curve and are doing the right thing. (See my post: Giving Turkey’s Central Bank the Benefit of the Doubt.) But, as Ho Woei Chen notes, this strategy is not without risks. Those EMs, like Turkey, which are running large current account deficits and are heavily dependent on foreign capital inflows to fund it, have to hope their strategy does not trigger major capital outflows. Other EMs, like Brazil and Indonesia, that have strong reserve positions and lower levels of external debt are in a better position to weather an episode of capital outflows.

3. Here’s What the Wall Street Protesters are So Angry About

By Henry Blodget, BusinessInsider

Blodget, a former top-ranked Wall Street analyst, looks at what’s behind the Occupy Wall Street protests and provides some excellent graphs to illustrate his points. His conclusion is that they have legitimate gripes: “Inequality in this country has hit a level that has been seen only once in the nation’s history, and unemployment has reached a level that has been seen only once since the Great Depression. And, at the same time, corporate profits are at a record high.”

EM Muser: As I discussed in a post a while back, a growing economy – an expanding pie – is generally a very good thing, but there are different kinds of growth – some much more healthy and sustainable than others. There’s ‘jobless growth’, debt-fueled growth, as well as growth accompanied by higher levels of inequality and these are not mutually exclusive. (See my related post: Unhealthy Obsession with GDP.) Income inequality in the US is now worse than in Iran, India, or Russia, while corporate profits are near an all-time high. This situation seems like it can’t be sustained indefinitely, and the Occupy Wall Streets are a reminder.

4. Capital controls

By Lex, FT

This column concedes that perhaps capital controls are not as bad as they have been made out to be. The flight of speculative investment is blamed for the sell-off in emerging Asian assets in August and September, and the column notes that if these investors had longer-term horizons, they wouldn’t have pulled out. The conclusion is: “For authorities in Taiwan, India, Indonesia and Thailand, all of which have toyed with measures to keep out undesirables, the big Asian sell-off should also be instructive. A new, stronger consensus could emerge: that capital controls are a legitimate tax on those least willing, but most able, to pay it.”

EM Muser: Capital controls have gotten an undeserved bad rap. I am glad to see that the long-held view that any and all capital controls are bad is starting to change. Even the IMF now supports capital controls in certain circumstances. (See my related post: Brazil’s Capital Controls: How Successful?)

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.

 

EM Currencies: Same Same But Different*

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Investors fled out of EM currencies at the height of the global financial crisis and retreated into safe haven currencies, such as the Swiss franc and Japanese yen. The recent market turmoil triggered a similar pattern, as EM currencies continue to be risk-sensitive. But there’s now greater variation. Certain EM currencies have shown considerable resilience and I expect greater differentiation among EM FX going forward.

Flight to Safety – Where’s That?

The VIX index – which measures the implied volatility of the S&P 500 and is used as a proxy for risk sentiment – rose to its highest level in over two years on August 8 and remains elevated. In reaction to this spike in risk aversion, most EM currencies slipped against the US dollar, as seen in Figure 1 below.

Figure 1: Most EM currencies weakened against the USD in early August when risk aversion spiked

Source: Oanda, author’s calculations

Investors’ gut reaction in times of market stress is to retreat from emerging market currencies. However, there are signs of gradual change. Some – such as the Chilean peso, Czech koruna and Indonesian rupiah – showed considerable resilience in early August, in contrast to their sharp weakening at the height of the global financial crisis. (See Figures 2, 3 and 4 below.) Financial commentator Martin Hutchinson recently went so far as to call the Chilean peso a ‘safe haven’ currency.

Figure 2: Select South American Currencies in Comparison

Source: Oanda, author’s calculations

The Brazilian real and Chilean peso have steadily strengthened against the US dollar since the height of the global financial crisis, albeit to a lesser degree than the Swiss franc, a major safe haven. When the S&P 500 plunged in early August, the Chilean peso held relatively steady, while the Brazilian real weakened, though it so far has not plunged like it did in late 2008-early 2009.

Figure 3: Central European Currencies in Comparison

Source: Oanda, author’s calculations

The Czech koruna, Hungarian forint and Polish zloty are all highly correlated with the euro, which is not surprising given these economies’ strong ties to the eurozone. As a result, these currencies are vulnerable to an intensification of the eurozone crisis.

Meanwhile, high levels of Swiss franc borrowing among Hungarian households’ [See related post: Hungary Mortgage Relief: Another Move to Delay the Pain) and moderate levels of franc borrowing among Polish households are also weighing on these currencies. As the Swiss franc has surged (given its safe haven status), there are concerns that it could slow economic growth and potentially even threaten financial stability. Notably, the Czech Republic – which has scant levels of fx-denominated borrowing and a lower public debt burden relative to the rest of Central Europe – has seen its currency diverge from the other two since mid-2010.

Figure 4: Select Asian Currencies in Comparison

Source: Oanda, author’s calculations

The Indonesian rupiah and Philippine peso showed considerable resilience against the USD, relative to other EM currencies, at the beginning of August. Authorities in both these countries have traditionally not shied away from intervening to smooth out volatility. In fact, Indonesia’s central bank recently said it plans to support the currency by purchasing IDR-denominated government bonds if there’s a large sell-off. As for India, the rupee dipped considerably against the USD in early August. India’s high current account deficit and large public debt burden make the INR more vulnerable to sell-offs in times of market stress.

Structural Change Afoot

Problems in advanced economies look to be more structural than cyclical, suggesting they’re not going to be resolved anytime soon. The US lost its prized triple-A rating from S&P on August 5 – the first downgrade in the country’s history. Meanwhile, the eurozone crisis continues to gather momentum, with Italy and now France coming into the spotlight. The broad political consensus needed to tackle these issues is lacking.

We’re moving toward a more multipolar world where the economic clout of emerging markets will grow ever larger, as Lupin Rahman of PIMCO describes. I also touched on this gradual structural shift in my post: Can Emerging Markets Replace the US as the World’s Consumer of Last Resort?.

The bottom line is that emerging markets are not immune to ripple effects from problems in the US and eurozone given their strong trade and financial ties. Nevertheless, their longer-term prospects are generally brighter than those in the developed world (with certain exceptions) given their lower debt burdens, more favourable demographics and faster economic growth.  (See related posts: The Double Whammy: Debt and Demographics and Emerging Markets: Fiscal Health Check)

As a result, I expect old patterns – where investors automatically flee away from all EM assets in times of trouble – to gradually change. Signs of that shift are already apparent, as noted above.

*See Wikipedia for explanation of title phrase ‘same same but different.’