The package is clearly of historic importance, and forces those in the investor community who remain unconvinced to assume, by extension, that the liquidity stresses seen in peripheral economies outside of Greece can trigger a chain reaction that would derail half a century of European economic integration.
Markets are focused on timely implementation for now: The mechanism needs to be approved and delivered without delay. Investors worry about signs of severe political stress among euro area members as it has a strong bearing on their weighting of tail macro risks.
Clarity of communication and of thought from policymakers and a credible path to fiscal sustainability are key for the longer term: We remain in an investing environment, driven by factors way outside the comfort zone of investors. The return of confidence in markets and the reduction in risk premia depends to a critical extent on policymakers laying down a clear and credible path to both mutual assistance and fiscal sustainability.
We therefore expect investors to continue hedging against tail risks (which are now of historic proportions) and elevated volatility: The controlled, but continuous, widening of a variety of credit and money market spreads is a product of investors' need to hedge against severe tail risks until the stabilisation package is delivered and weaker countries regain credibility with investors.
The call is on replay until end-Monday May 24 on +44-1452-55-00-00, pin is 748-193-02.
Summary and Conclusions
For our views on the package, we invite readers to refer to our earlier notes on the matter, Europe Economics: Fast-Track to Fiscal Union? (May 10, 2010) and Europe Economics: A Euro Area Stabilisation Fund (May 8, 2010).
• "Biggest ‘all in' poker hand in history" according to Professor Enderlein, and we agree. European Monetary Union was anchored on two institutions, an independent ECB and a Stability and Growth Pact (SGP) that was supposed to limit government indebtedness and thus the risk of sovereign bailouts among member states. With the SGP having failed, monetary union now rests principally on ECB credibility. After May 10, Monetary Union will also rest on the conditionality elements of the stabilisation mechanism correcting the fiscal sustainability paths of euro area member countries.
• Towards a fiscal union? If, as expected, the poker hand is won, the result may actually be a much tighter fiscal framework and more integrated economic governance in the euro area. The mutualisation of sovereign risk in the euro area would also imply steep penalties for any country losing the umbrella of the regional debt guarantee. Further proposals on economic governance in the euro area coming from Berlin this weekend would represent, in the near future, an acceleration in eurozone integration that would reverse a trend of the years following the introduction of the euro where European institutions were weakened not strengthened. Professor Enderlein does not expect a reform of the EU treaties to achieve this, or not, in the short run - rather, fiscal reform would be operated through the SGP-specific protocols which can be amended by unanimous decision of the member states.
• But there is no plan B: If the package were to fail, deterioration in financial and economic fundamentals is expected to be immediate. Europe would also enter into a prolonged and very difficult period of elevated political and economic uncertainty, which would structurally impact risk premia across financial assets.
• Without Germany on board, there is no bailout package: A smaller country not taking its commitments to the finish line will not kill the bailout, but Germany is irreplaceable both financially and politically. Hence, the political discrepancies between Germany and other large European countries need to converge. The road towards policy convergence remains a source of delays, contradictory statements by politicians and generally negative headlines. Investors should note, however, that some of this noise forms part of the normal practices of EU policymaking. But that tension, at the same time, also forms the basis that triggers a much more serious political crisis in Europe that would have very negative repercussion for financial markets. Understanding German concerns and policymaking processes is thus relevant for investors. Chancellor Merkel lost an important regional election two weeks ago and control of the upper chamber of parliament. However, the opposition Social Democrats are expected to vote in favour of financial assistance to the weaker members of the eurozone, both because of political conviction and because the failure of the package is an even worse alternative. In exchange, however, the Social Democrats will likely demand a more interventionist regulation of the financial services industry.
• Things to get done in the coming weeks: EU governments and the IMF are still negotiating the fine print of the package that was agreed at the political level on May 10. A lot of work remains to be done on the SPV that will fund governments. Its creation will require an international treaty and the architecture of the stabilisation package is new to the functioning of European Union institutions. The interaction between the IMF, the EU and member states also needs to be fully laid out. This package will then need to be approved in each country according to national law, often via a parliamentary vote. We hope that the German parliament will be in a position to vote on the package on May 21.
• The German constitutional court risk: Professor Enderlein expects the law enabling Germany to contribute to the funding mechanism to be immediately challenged in its constitutional court. This court has ruled in the past for a very conservative reading of the EU treaty's no bailout clause (Art.125) that forbids members of the EU from providing financial assistance to other member states facing fiscal sustainability problems. The court, however, also ruled that Art.125 could be bypassed under circumstances of risk for the Union itself rather than a specific country. This is the legal argument Professor Enderlein expects the German government will use if and when the law is challenged in the court. While Professor Enderlein expects the German government to have its views upheld by the court, this remains one of the key event risks the markets will be facing in the coming weeks.
• The EU-wide package is different from the Greek package: The stabilisation mechanism will have three components: €60 billion from an existing financing facility drawn from the resources of the EU budget, and €440 billion in loans and lines of credit drawn from a newly formed special purpose vehicle whose liabilities will be guaranteed by participating member states. While the €60 billion facility is available to all 27 EU member states, the €440 billion SPV will only be available to the 16 members of the EU who have adopted the monetary union. Finally, up to €220 billion will be made available by the IMF. The euro area stabilisation mechanism announced a week ago used the emergency powers allowed under Art. 122 of the Treaty. It is therefore an operation of the EU as a whole rather than its member countries. Greece, on the other hand, was structured as a set of bilateral guarantees among countries belonging to the EU.
• Finally, on the ECB: We think that a strong ECB intervention in the debt markets would weaken the institutional strength of European Monetary Union, but we see this as a possible outcome if central bankers were to feel they were losing their grip on the situation. Pushback from Germany on this extension of the ECB's remit has been and would continue to be very forceful we expect. In this regard, Professor Enderlein noted how, absent inflationary risks, the ECB is meant to support the general economic policies of the European Union according to the treaty, and he thinks this would extend to bond market intervention. We think that questions around ECB independence and the ‘contamination' of the ECB's balance sheet would only grow louder, the longer the ECB keeps intervening.
While all eyes today are focused on short-run developments in euroland, the prospects for long-term growth in Brazil are linked to its progress on the infrastructure front. Last week we explored the outlook for infrastructure in Brazil, (see "Brazil Infrastructure Prospects", This Week in Latin America, May 10, 2010); this week we probe the macroeconomic implications if Brazil succeeds in increasing its infrastructure investment. While we expect Brazil to double its infrastructure investment ratio to 4% of GDP over the next decade, the main downside risk is slippage in policy and implementation. For a more detailed look, please see "Brazil Infrastructure: Paving the Way", Morgan Stanley Blue Paper, May 5, 2010.
Macroeconomic Scenarios
Assuming Brazil succeeds, what would the economy look like in the next decade? In our base case scenario, we expect that Brazil manages to double its investment in infrastructure, to 4% of GDP, it moves ahead with some reforms, and real GDP growth averages 5% over the next ten years. The currency appreciates in purchasing power parity (PPP) terms, although inflation differentials work against much nominal appreciation. Policy interest rates continue to decline over time, gradually converging to international standards. For its part, the fiscal outlook depends on how the authorities choose to fund increased infrastructure investment. All else equal, an annual increase in public sector spending on infrastructure of 1-2% of GDP would mean that the debt stock ends up 10-20% of GDP higher than otherwise over the course of a decade, if the authorities resort to increased indebtedness to fund additional spending.
Our base case scenario looks at simple averages over the next decade; reality will undoubtedly be much more complex and non-linear. We feel confident that infrastructure investment will eventually pick up. Infrastructure is high on the policy agenda, higher investment ratios have been obtained before (in Brazil and elsewhere), and infrastructure looks bound to remain a hot topic in light of the 2014 World Cup, 2016 Olympics and pre-salt oil investments. The main downside risk is slippage in policy and implementation. Infrastructure investment is unlikely to suddenly double overnight. Instead, it may well remain relatively low in the near term, before it picks up more significantly later on, as catch-up progress proves back-loaded. The outlook in part also depends on the willingness and ability of the administration that takes office in 2011 to move forward with reforms and infrastructure investment.
Brazil's overall investment-to-GDP ratio would need to increase markedly. After all, there is a significant correlation between infrastructure investment in particular and overall investment. Infrastructure investment in Brazil has averaged about 2% of GDP in the latest decade, while overall investment averaged about 17% of GDP. By contrast, when infrastructure investment in Brazil was about 5% of GDP a few decades ago, overall investment was 22% of GDP. If Brazil's infrastructure investment is to meaningfully increase, then the overall investment-to-GDP ratio would likely exceed 20% of GDP.
In fact, Brazil's overall investment-to-GDP ratio is too small. Brazil's average investment-to-GDP ratio of about 17% stands well below the median ratio of 25% for comparable investment grade peers which S&P rate as BBB. Brazil's overall investment ratio also stands below regional investment grade peers like Mexico (23%) and Peru (24%). And Brazil's investment ratio lags well behind India (38%), Russia (24%), and China (44%). Brazil's current infrastructure investment pace of 2% of GDP is well below the average 7% of GDP ratio seen in India, Russia and China, even though the precise definition of infrastructure can vary from country to country.
Prospective oil-related investment helps, but cannot alone save the day. A BNDES mapping of prospective investments in oil and gas suggests that annual investments in this sector could increase from 1.5% of GDP on average in 2005-08 to 2.3% in 2010-13. The resulting investment gain of 0.8% of GDP would be welcome, but insufficient by itself to dramatically change Brazil's overall macroeconomic investment picture.
Increasing infrastructure investment is tied to increasing overall investment in the economy. In the national accounts, total investment must equal total savings. Higher investment requires higher savings. In turn, an increase in total savings comes from higher domestic savings, higher external savings, or a combination of the two.
Higher overall investment would likely require increased external savings, in the form of a wider current account deficit. There is a significant historical correlation between investment and the current account in Brazil. A scenario where infrastructure and overall investment increase significantly amid faster domestic demand growth would likely mean that Brazil's current account deficit could widen, perhaps to 3-5% of GDP for several years - at least until increased domestic oil production and a better oil export mix eventually boost total exports more significantly. As a reference, Brazil's current account deficit has been almost 2% of GDP on average since the 1980s, but averaged close to 4% in the 1970s, when the economy was growing much faster.
Most of Brazil's current account deficit should be covered by foreign direct investment, if all goes well, although we expect that portfolio flows will also play a role. Our previous work has highlighted that Brazil's market size and growth outlook help attract FDI flows, but its infrastructure and public sector efficiency remain challenging (see "Brazil: What Is the FDI Outlook?" This Week in Latin America, September 21, 2009). Improved infrastructure, if combined with increased public sector efficiency, could go a long way towards supporting FDI inflows. If Brazil were to recover the market share of 3.5% of global FDI flows it enjoyed back in 1980, for instance, annual FDI flows into Brazil could reach 3% of GDP.
Higher investment could also come in part from increased domestic savings, private and/or public. Boosting private sector investment would likely depend on improving Brazil's business environment. Brazil ranks poorly on microeconomic indicators, according to an annual survey conducted by the World Bank (Doing Business). In the latest edition of this survey on local business conditions (2009), Brazil ranks 129th out of 183 countries under consideration.
To foster private sector investment, we think Brazil would need to contain its tax burden and simplify its tax system. Brazil's high tax burden and complex tax system are important hurdles to doing business in the country. According to the World Bank survey, Brazil ranks very low in terms of the amount of taxes and mandatory contributions on labor paid by businesses as a percentage of commercial profits; the average corporate tax rate in Brazil is 69%, but only 41% in the median country in the survey. The situation is even worse when it comes to the time it takes to prepare, file and pay (or withhold) corporate income tax, VAT and social security contributions. Brazil ranks dead last in the survey.
Brazil's tax burden has been climbing steadily for more than a decade and we are concerned that it is too high by international standards, once adjusted by Brazil's per capita income. The concern is that a high and rising tax burden can be bad for growth, as it crowds out the private sector and can hurt private sector investment.
Another factor to support private sector investment in infrastructure is the development of local capital markets. BNDES has played a crucial role in providing subsidized financing for long-term projects like infrastructure. However, the authorities may need to reassess the role of BNDES over time, for micro and macro reasons. From a microeconomic perspective, local capital markets need to develop to provide diversified sources of long-term financing for private sector investment plans.
From a macroeconomic point of view, subsidized BNDES lending carries fiscal implications as well - if not always explicitly. For instance, when the Treasury issues debt in order to help fund BNDES subsidized operations - as it has done lately - the federal government's gross debt goes up but the net debt does not change immediately, although there is an implicit negative carry over time. While most observers seem to focus on Brazil's net debt (42.9% of GDP at end-2009) as the main benchmark indicator, Brazil's public sector gross debt is significantly higher (62.9% of GDP at end-2009). A strategy of funding infrastructure investment through Treasury-based BNDES subsidized lending could further widen the gap between gross and net debt statistics, before any considerations about liquidity and asset quality of the BNDES lending portfolio.
As for spurring private sector savings, structural reforms like pension reform could prove important, too. Brazil's current pay-as-you-go pension system, and its many distortions, provides little incentive for higher long-term household savings. Here, Chile's experience with pension reform and savings might provide useful lessons.
Oil Wealth: No Panacea
Commodity wealth can help, but it is no guarantee of increased infrastructure spending. One channel through which the pre-salt oil exploration could indirectly help infrastructure prospects is through the fiscal accounts. In principle, rising fiscal revenues from the oil sector could enhance the government's ability to spend more in infrastructure. Payments from Brazil's giant oil company to the public coffers (mainly royalties, but also taxes and special participation contribution, besides dividends) were 0.9% of GDP last year, or about 6% of federal government revenues.
We see two caveats on prospects for oil-related fiscal gains. The first has to do with the timeframe and magnitude of prospective oil gains. While capacity expansion plans by Brazil's giant oil company are impressive (above US$ 200 billion in 2010-14), it will take time before new oil output runs at full speed. And only about a third of oil dividends get transferred to the government, given the ownership structure of Brazil's main oil company. Our sector equity analysts estimate that total oil-related payments to the government would increase to about 1.2% of GDP by 2014, or a gain of about 0.3% of GDP relative to 2009. Numbers would grow over time, as oil production ramps up. Under certain assumptions, annual fiscal earnings from oil could eventually double as a share of the economy from current levels to reach about 2% of GDP by 2020 - although our sector analysts believe that there are upside risks to potential oil reserves.
In other words, it will probably take several years before the authorities can rely on a significant fiscal boost from oil revenues, assuming all goes well. It is worth keeping in mind, too, that international oil prices can prove highly volatile, adding uncertainty to prospective fiscal gains from oil.
A second caveat is related to uncertainty about how the authorities would handle future oil-related fiscal gains. Discussions in congress suggest that there are already many ideas about how to spend future oil gains, and not necessarily on infrastructure projects. The experience with commodity gains in other countries in the region can provide useful lessons for Brazil. Oil-rich Venezuela provides a cautionary tale: The country ranks low in international infrastructure surveys, illustrating how windfall oil wealth does not necessarily translate into better infrastructure. At the other end of the spectrum, Chile's fiscal experience in handling gains from copper is often cited as a model of prudence to be followed. And Chile ranks high in cross-country infrastructure surveys.
Further, there is not a strong positive correlation between natural resource wealth and economic growth. Commodity prices can decline over time. Natural resource sectors can crowd out manufacturing, a concern if the sector offers positive spillovers for growth. International commodity prices are notoriously volatile. And abundance can undermine institutions, especially if it fosters rent-seeking.
In addition, natural resource wealth can be a double-edged sword, as swings in commodity prices can entail macro instability, through the real exchange rate and government spending, imposing unnecessary costs. The international literature suggests that oil booms typically entail higher government spending on two main budget items: public sector investment and government wage bill. Infrastructure investment is surely welcome if well designed and implemented within a long-term framework - as opposed to a surge in poorly designed projects which remain unfinished or strapped for maintenance funds when commodity prices go down.
Bottom Line
Brazil should be able to grow faster if it succeeds in increasing its currently low investment-to-GDP ratio - in infrastructure and overall. The currency would be supported despite a current account deficit, and policy rates would converge further to international standards over time. In turn, debt implications depend on how Brazil handles its fiscal challenges. While there is much hope that prospective oil-related gains can solve many problems, natural resource wealth can prove to be a double-edged sword.
1Q10 GDP Beat Expectations
The Hong Kong economy continued on its recovery path in 1Q10. The economy grew 8.2%Y in real terms (+2.5% in 4Q09), beating our (+6.9%) forecast but falling slightly below market (+8.3%) expectations, partly aided by the low base from a year ago. On a QoQ seasonally adjusted basis, the economy expanded 2.4%, as the robust growth momentum in domestic demand more than offset the sharp deterioration in the net exports position.
Robust Growth Momentum in Domestic Demand
Domestic demand demonstrated robust momentum, gaining 16.4%Y in 1Q10 after posting double-digit growth in 4Q09. Private consumption jumped 6.5%Y in 1Q10, up from 4.8% in 4Q09. Fixed investment surged 10.5% (+14.1% in 4Q09), reclaiming positive QoQ growth at a relatively modest 0.7% in real terms (versus -4.6% in 4Q09). Private sector investment gained 2.7%Y in real terms (of which machinery, equipment and computer software rose 13.0%), pointing to improving business sentiment and commercial activities. Meanwhile, growth in public sector capex accelerated to 22.7%Y (versus +12.4% in 4Q09) on the back of the government's initiatives to boost the economy and jump-start some large-scale infrastructure projects.
However, similar to previous quarters, the change in stocks again accounted for a considerable share of real GDP, rising to 6.6% in 1Q10 from 4.8% in 4Q09 and 4.0% in 3Q09. In other words, stock accumulation contributed 8.4pp to the incremental change in the headline real GDP growth rate, acting as the biggest offset to the 12.1pp plunge in the contribution from the goods balance. By comparison, domestic demand (excluding change in stocks) and private consumption contributed 6.5pp and 4.0pp, respectively.
Net Exports Position Hints at Signs of Improvement
The goods balance continued to worsen in 1Q10, posting a record HK$94.4 billion deficit in real terms and contributing a negative 12.1pp to the incremental change in the headline real GDP growth rate (versus -10.4pp in 4Q09 and -8.0pp in 3Q09). Despite the apparent deterioration, we see strong signs of improvement as exports of goods rebounded markedly in 1Q10, surging 21.6%Y, compared to -2.9% in 4Q and -13.2% in 3Q. The powerful turnaround was driven by strong growth in exports to the Mainland and other neighboring Asian countries, with exports to the US gaining strength and resuming positive growth after quarters of significant decline. In the meantime, imports of goods also increased noticeably (+28.0%Y versus +3.3%Y in 4Q09) on the back of resilient domestic demand. We expect that exports will likely carry on its tremendous revival as the economic recovery around the globe (especially Asia) begins to gain traction.
Service Exports to Be a Key Growth Driver
Although the net exports position continued to contribute negatively to growth, it is worth noting that both exports and imports of services increased much stronger than expected. Service exports gained 17.9%Y in real terms (versus 8.9% in 4Q09), while service imports rose 10.2% (versus 2.5% in 4Q09). In addition, inbound tourism is seeing a clear revival in recent months. The latest data point to an upbeat recovery, with visitor arrivals up 16.5%Y in 1Q10 after growing 9% in 4Q09. Overall inbound tourist spending grew an impressive 16.3%Y in 4Q09, up from 1.1% in 3Q09, and we expect the positive momentum to carry on in 1Q10. Meanwhile, the ‘tourism surplus', i.e., the difference between inbound tourist spending in Hong Kong and outbound consumption abroad, widened to 3.3% of GDP (HK$14.8 billion) in 4Q09 from 1.3% in 3Q09 and the trough of 0.6% in 2Q09 amid the global recession. The significant improvements in service trade as well as inbound tourism in the previous two quarters further reinforce our view of a revival in Hong Kong's role as the region's service center as the macro environment improves, and we believe that the continual recovery in service exports will be a robust structural growth driver for the Hong Kong economy in the next few years.
Monetary Conditions Remain Accommodative
In contrast to market anxiety over the possible reversal of capital flows from Hong Kong upon policy tightening across the globe in 2010, the latest data actually suggested a rebound in our proxy of the total liquidity stock in March, as banks increased their aggregate net foreign asset position by US$4.8 billion, after running it down for five straight months (by a total of US$18.4 billion). Sustained low HK$ interest rates and a marginal widening in the negative spread against US$ counterparts suggest a similar situation in April. Ample liquidity has continued to give support to asset (equity and property) prices in Hong Kong, notwithstanding concerns over monetary tightening (in China as well as rest of the world), administrative measures (in China) and policies to cool the property sector in Hong Kong. Nevertheless, we shall continue to monitor changes in monetary conditions, as policy exits around the world and possible reversal of capital flows still represent a significant threat to Hong Kong's economic recovery in 2010. However, we reiterate that the stock of excess liquidity accumulated since late 2008 is considerable, offering a meaningfully sizeable buffer for outflows before interest rates would come under significant upward pressure (see Hong Kong Economics: Monetary Conditions Monitor, May 4, 2010).
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