China: Time to Rebalance?

Overview

- Although China’s government continues to ensure world policymakers of China’s intentions towards rebalancing the economy, the measures undertaken to date clearly show China’s preference for an export-growth model.

- Governmental investments on infrastructure combined with an undervalued Yuan - despite strong GDP, high exports, and double digit inflation rate - demonstrate China’s unwillingness to rebalance its economy in the near term.

- China’s oil imports are expected to reach 30% of total non-OECD demand, establishing China as a major force driving oil demand and economic growth globally.

- To shift China’s economy from overinvestment in infrastructure needed to support an export driven economy to a consumer led economy, the government must address a high consumer savings rate by increased spending on health, education and pension systems.

- Furthermore, China’s consumers could be given more spending power to support imports if the

Central Bank would allow the Yuan to appreciate. Yuan appreciation is delaying the struggling act of rebalancing of an export growth model towards consumer driven.

Despite the global economic turmoil, China was able to weather the financial crisis remarkably well.Although it suffered the highest level of export drop in the last ten years, China’s GDP grew by 10.7% year-over-year in the fourth quarter of 2009 due to a massive stimulus package of 4bn Yuan. This stimulus package created numerous infrastructure development projects and pushed China to secure natural resources supply throughout Central Asia, Latin America and Africa. As a result, China’s import levels surged in 2009 and supported the country’s role as the major driving force behind the worldwide economic recovery.

Oil Imports drive economic recovery

While sluggish economies for most developed markets resulted in a sharp decline of oil imports, non-OECD oil imports were remarkably strong and are expected to continue an upward trend. The BRIC demand is expected to reach 9.2% year-over-year growth in 2010 and 5% year-over-year growth in 2011, while China alone is forecasted to account for 30% of non-OECD demand - establishing its role as a major driver of emerging market oil demand.

Due to the strong economic growth in emerging markets, which is typically supported by natural

resources consumption, emerging markets in general will continue to drive global oil demand and keep prices high. China, with some of the most oil intensive industries in the world, will continue to drive prices and global oil consumption. As a result, the price for 2010 WTI crude oil is expected to reach USD 90/bbl and USD 110/bbl in 2010 and 2011 respectively based primarily on China’s demand fundamentals.

Furthermore, China’s strong demand has led to the rebalancing of natural resources flow from developed markets to emerging markets, which is compensating for the sluggish economic growth in developed markets. This has been already recorded in Q3 2009, where demand from China and India overtook the United States for Saudi Arabia crude oil, shifting Saudi’s attention towards emerging markets, in particular to China. In December 2009, China’s crude oil imports reached a peak of 1.2m b/d and rose by 14% year-over-year.

Even though the US still leads the world’s oil consumers in terms of consumption, its imports fell

significantly in 2009 and a rebound is not foreseen for 2010 - while China’s demand grew constantly. While oil imports to the US well fell by 5.1% yoy and 4% yoy in 2008 and 2009 respectively, China’s oil imports grew by 5% year-over year per annum on average in the period ranging from 2008 to 2010.

Although China is blamed for importing goods which are used as input for the export product, oil demand in the last years was related to asphalt, petroleum coke and naphtha, which is mainly used for development of infrastructure projects in China. This is a leading indicator of consumption within the country, although the development of infrastructure is interpreted as the usual manner of overinvestment in order to increase GDP levels in the medium term.

The question is will the infrastructure investment undertaken by China’s government boost consumer confidence in the near term?

China as a major consumer market

Given the country’s population size as well as the significant increase of the middle class, China’s

consumption is expected to overtake Germany’s by 2015 and Japans by 2025 while becoming third largest consumer market in 2025 in purchasing power parity terms. But for now China, with the population 4.5 times larger than US, consumes only 25% of the US consumption.

To get Chinese consumers to spend is easier said than done. Achieving this goal would strongly reduce China’s dependence on exports for growth, reduce the tensions with global policymakers on their overvalued currency and, more importantly, it would boost the standard of living for its population. To boost its domestic consumption China has to overcome a long structural imbalance. Being the world’s largest exporter of goods, China now has to change its export dependency on the world’s major developed economies and boost its own private and public consumption.

In order to increase the level of consumption in developed economies, governments typically rely on expansionary fiscal policy, in particular tax cuts. According to the Institute for International Economics, this measure seems however to be less effective in China where income tax amounts to 1.1% of GDP as compared to 7% of GDP in US. Accordingly, further tax cuts in China would contribute only an estimated 0.13 percent growth in GDP.

How long it takes China to shift its economy from overproduction and overinvestment to domestic consumption depends on the effectiveness of its structural policies which have to be worked out together with other global economies. But the more relevant question in the near term is how willing China’s government is to support a shift from an export oriented economy to a consumer driven economy through fiscal and monetary supply measures.

China’s savings

The past decade was characterized by high investment and extremely low consumption rates which gradually continued to decline resulting in high savings for Chinese consumers. The main reason behind this imbalance, which was reflected in a huge current account surplus, is the cautionary savings by the Chinese households and corporations due to the underdeveloped health, pension and educational sectors. To insure themselves against future uncertainty with regard to health and pension needs, households built-up a huge amount of savings in a defensive manner to be able to cover possible future healthcare and retirement expenses.

The question of interest is, therefore, whether China’s government plans to increase spending on behalf of the consumer in order to support consumer consumption. Instead, in 2009, while China’s Government already made its first attempt towards higher governmental spending, most of the funds were directed toward economically unviable infrastructure projects, it ignored

consumers’ concerns regarding future healthcare and retirement needs. The amount spent on hospitals and schools account for only 2% of total government spending - which is the lowest percentage among major countries.

By not responding to urgent consumer needs, the government has inhibited consumer spending and the saving rates will continue to increase accordingly. Given the government’s plans to continue making significant infrastructure investment, we believe that the government will remain unable to decrease precautionary savings in the short-term.

In conclusion, we believe that in the medium to long-term, for a country with a rising middle-class, there is good evidence that it can become a major consumer market once policy makers support increased social spending to allow consumers to lower savings and increase spending - which could be funded by gradually shifting public investment away from the export led manufacturing sector. In the near term, with the flat economic environment expected for developed countries, this shift would seem to be achievable.

Russia: Is The Recession Truly Over?

Overview

• Russia was strongly hit by the financial crisis which is clearly seen in its GDP contraction of nearly 9% on a year-over-year basis. A “V-shaped” recovery is not expected for 2010, although the country’s main macroeconomic indicators suggest that the recession is over.
• Russia’s international reserves reached USD 450 billion in December 2009 and are expected to grow next year as result of rising commodity prices.
• A struggling labor market has seen real wages drop and led to a negative impact on domestic consumption. The key economic driver, however, is led by foreign demand which rose in the third quarter of 2009 and is expected to boost Russia’s GDP to 3% in 2010 and 4% in 2011.

2009 was a bleak economic year in Russia and one of the toughest years on record in the post-Soviet period. While attracting high levels of capital inflows related to the oil boom in 2009, Russia, at the same time, experienced a sharp devaluation in the ruble.

The value of the ruble is considered to be one of Russia’s most pressing threats to economic stability and growth. The global financial crisis also impacted domestic liquidity and access to credit, although local banks and companies were able to borrow in foreign currency resulting in significant growth in net borrowings.

A sharp decrease in capital inflows in 2008, accompanied by plummeting commodity prices, resulted in the fall of fixed investments, private sector profits (necessitating the squeeze on labor costs) and productivity. This is reflected in Russia’s output, which contracted by almost 10% compared to the same period in 2008.

Some recovery was observed in the second quarter of 2009 where the industrial growth rate improved to -1% from -40% in the beginning of 2009 and exchange rates started to recover in 3rd quarter of 2009.

Although commodity prices are believed to have the most significant impact on Russia’s economy in 2009, it is important to mention that the downturn in output occurred despite relatively high commodity prices which were approximately on the pre-crisis level.

The question that arises is what are the major causes of such a sharp downturn in the economy which has shown steady growth for most of the last decade? One of the problems was the late response from Central Bank of Russia to implement the necessary measures such as monetary easing to stem the financial crisis.

While the European Central Bank (ECB) and U.S. Federal Reserve (FED) lowered their interest rates to historical levels and employed strong quantitative easing programs to boost the fragile economy, the Central Bank of Russia (CBR) decided to take the opposite direction by tightening its monetary policy and raising interest rates.

This move was seen as a measure designed to stabilize the ruble and avoid capital flight. The ruble is now expected to be relatively strong in 2010 based on the assumption that the US Dollar will strengthen only later in the year once the FED implements its exit strategy (if the dollar strengthens as the FED unwinds liquidity programs and raises rates, this could put downward pressure on the ruble).

Russia’s International Reserves
Based on plummeting Russian exports for most of 09, overall exports for the year decreased by 35% compared to 2008. As a result, many international think tanks and investment banks predicted a bleak outlook for the country’s trade balance – ie, a deficit balance. This, however, turned out to be the opposite due to an even greater decrease of imports year over year as result of a weak ruble and an increasing number of non-performing loans which in turn decreased the availably of loans in the second half of 2009 and the ability to fund trade flows. The country’s trade balance was a positive USD 110 billion in 2009 although down from USD 180 billion in 2008.

A positive current account and gradual strengthening of private capital flows during 2009 significantly increased the level of foreign currency supply while relatively high commodity prices kept the current account healthy resulting in an increase in international reserves at the end of 2009. Since commodity prices are forecasted to increase in 2010, which in turn will boost Russia’s international reserves further, although the level of USD 600 billion as of August 2008 is unlikely to be reached in 2010. The graphs below clearly demonstrate the positive correlation between commodity prices and the levels of international reserves.

The expectation is that despite a stronger ruble outlook for 2010, this will not hurt exports as Russia’s lower cost basis for commodities producers will more than offset any ruble appreciation and the CBR can, if necessary, intervene if a stronger ruble is hurting exports.

Accumulated international reserves provided Russia with more room to maneuver, allowing the Central Bank of Russia to intervene to either strengthen the ruble or to mitigate excessive appreciation. The process was observed in spring 2009 when the CBR first let the ruble strengthen and then started to purchase foreign currencies in order to prevent the further appreciation of the ruble. Building up international reserves is seen as a major source for bolstering Russia’s monetary base. During the financial crisis, the Central Bank of Russia, as a lender of last resort, started to provide loans to the country’s commercial banks and financing the budget deficit from its Reserve Fund.

The Labor Market, Sluggish Demand And The Rebound Of Exports
Although the country’s official unemployment level reached 8%, which is low compared to the US, the figure is not comparable. The reason for a relatively low level of unemployment in Russia are measures undertaken by companies such as a shift from full-time to part-time employment with reduced wages and forced unpaid vocational leaves. The overall impact is negative, since real wages sharply decreased, resulting in negative demand and a lower level of imports.

The lack of domestic demand and difficult loan conditions are expected to have a negative impact on overall investment growth. Since state-sponsored investments dropped sharply, industrial capacity utilization reached 2003 levels - which were at 60% - compared to 74% in 2008.

Despite expected improvement in international reserves, state investment is expected to decline further this year, while budget expenditures will drop from 38% of GDP as of 2009 to 33% of GDP in 2010. Further cuts are expected in federally targeted programs which already decreased by 15% on a year over year basis and now account for approximately 2% of GDP. Accordingly, state-sponsored investment growth is expected to reach a meager 2.5% recovering from a 17% drop in 2009.

For 2009, the Russian federal budget deficit was expected to reach 8% as a result of lower tax revenues. The Ministry of Finance confirmed that the actual level was lower than anticipated. Russia’s trade balance will remain stable while exports will likely shift from Europe to commodity hungry countries such as China. Although the domestic demand of a population of 150 million people is an important component of the Russian economy, external demand however will continue to be the main driver behind economic growth. Net exports, strengthened by stable oil prices and restored demand, had already picked up in the 3rd quarter of 2009 resulting increase in25% export revenues on a quarter over quarter basis. This trend is expected to continue as net exports will remain one of the most important sources of revenue for the country in 2010.

In conclusion, following a strong contraction in output in 2009, GDP is unlikely to reach 5-6% growth as predicted by some international think tanks due to continuing sluggish domestic demand. Faster than expected emerging market recovery forecasted by IMF in January 2010 along with the strong demand for commodities, particularly from China, will boost Russia’s output to 3% in 2010 and 4% in 2011, clearly signaling that the recession is over. The process to fully restore Russia to its overall pre-crisis levels, however, will be gradual and will likely not occur in until the first half of 2012.

Central and Eastern Europe: The Re-balancing of Debt and Equity Capital In-Flows

Overview

• Capital In-Flows to Emerging Europe will increase from USD 20.3 billion in 2009 to USD 179.4 billion in 2010 while external financing will be equity dominated.
• Direct equity investment is expected to rise by approximately 150% and reach its pre-crisis level in 2010.
• Although local commercial banks show a slight recovery in 2010, their ability to boost lending volume to support the region’s growth remains limited.

The recent financial crisis characterized by the fallout of Lehman Brothers, Bear Stearns, and Merrill Lynch significantly hit Europe’s emerging markets. Although the crisis already reached the world’s developed economies in 2007, many countries in the region, with exception of the Baltic States and Kazakhstan, were enjoying an extraordinary period of decoupling of output and credit growth.

Once the crisis reached emerging Europe in the last quarter of 2008, many of the CEE countries suffered a much larger output decline than was experienced in any of the world’s other regions. Even though the CEE region was significantly affected due to the negative double digit GDP growth in several countries, positive single digit growth was observed in several other emerging European economies. Despite the financial crisis that griped the majority of the CEE region, Poland emerged as a country with a positive GDP output of 1.4% year over year.

From 2001 to the first half of 2008, emerging Europe experienced high volumes of capital inflow, rapid expansion in investment and consumption, as well as a credit boom through strong external indebtedness of the private sector. Most of the emerging European economies debt was denominated in foreign currencies; therefore strong depreciations of domestic currencies made creditor banks, corporate and household borrowers even more vulnerable.

Foreign Direct Investments

The FDI flows to emerging market economies in particular Asia and Latin America, were more stable than other classes of capital. However, the behavior of FDI flows into emerging Europe raised concerns. With FDI growth reaching its peak in 2007 yet remaining attractive despite previous financial crises, FDI into Central and Eastern Europe and the CIS states strongly decreased for first time in 2009.

One of the reasons cited is that 30% of FDI was related to M&A activities which were often financed by funding from international banks. This is justified based on the issuance data of syndicated loans which significantly decreased in 2009. Another factor which contributed to a sharp decline in FDI, especially in the Czech Republic and Poland, has been withdrawal of funding by international banks in order to overcome liquidity shortages in their domestic markets.

Distressed market conditions - following their path from advanced to emerging economies - put further pressure on emerging European markets, resulted in limited availability of external finance and rising costs. Additionally, a strong decline in private equity inflows, a weakening of domestic currencies, rising spreads on sovereign debt and rising bond yields were all seen as well.

Primary issuance of debt reached its bottom in international markets while secondary trading of emerging markets bonds was significantly reduced even for sovereigns.

The crisis arrived to CE countries (Czech Republic, Poland, Hungary and Slovakia) only in third quarter of 2008 and significantly worsened in last quarter of 2008. In the case of Hungary there was no bidder for governmental bond auctions in October 2008. This example clearly expresses the concerns and doubts of investors on Hungary’s ability to meets its external financing commitments.

Cross-Border and Local Lending

The financial crisis worsened once investors, in particular non-residents, started to withdraw funds from domestic bond markets in the CEE region and invest them into more liquid foreign securities. Another factor which significantly limited the ability of emerging European corporations to borrow in international markets was the reversal in cross-border lending.

According to the Bank of International Settlement, banks from

advanced economies significantly reduced their cross-border lending activity to emerging markets by USD 205bn in the last quarter of 2008 by limiting their exposures to all sectors of the economy and in particular to banks. A sharp decline in cross-border bank lending in Europe pushed domestic corporate borrowers to borrow in local markets instead.

The question of interest is whether local markets have the capacity to provide capital needed and how much should local lending increase if all external borrowings were shifted to local banks. This is measured by relating non-bank cross-border borrowings to banks’ domestic lending. The ratio reached 30% at the end of 2008, suggesting banks’ lending would have to rise by 1/3. The ability of local banks to boost its lending volume remains limited as they currently moderate the lending in order to reduce loan to deposit ratios which reached over 100% in most of CEE region.

The financial crisis of the last 18 months left a negative impact on many countries within the CEE. Being cut off from credit on one hand and equity flows on another, the region suffered a strong cyclical downturn resulting in a significant decline in output in 2009. Although region’s output will outperform the output of advanced economies, the outlook for 2010 remains challenging compared to other emerging economies.

Emerging Economies Global Output Growth

Percentage change over previous year

Source: Institute of International Finance, Capital Flows to Emerging Market Economies Trends in Capital In-Flows

Trends in Capital In-Flows

Severity of financial crisis was characterized by unprecedented slowdown of global economic activity, therefore exact assessments on how and what amounts of private capital inflows will go to emerging markets in coming years is highly uncertain. However, the Institute of International Finance projects strong increase in equity investments over debt to all emerging market economies.

The data from pre-crisis capital flows to emerging markets was strongly dominated by rapid growth in commercial bank lending; the post-crisis capital inflows will shift to more equity dominated inflows leading to an important shift in the debt-equity mix for emerging economies’ external financing.

Although emerging Europe absorbed drastic losses from the sharpest decrease in net in-flows in 2009, it will benefit from the strongest net improvement in 2010. Total private capital in-flows to the region are forecasted to reach USD 179.3 billion; USD 112.9 billion will be equity based investments.

Private Capital Flows to Emerging Economies

USD billion

Source: Institute of International Finance, Capital Flows to Emerging Market Economies

In case of emerging Europe, the projected equity based capital flows will increase from USD 74.8 billion in 2009 to USD 112.9 billion in 2010 while credit volume is expected to reach USD 66.4 in 2010 billion from USD -54.4 billion as of 2009.The contribution of commercial banks to the local capital supply is anticipated to be meager 16% comparing to approx. 40% as of 2007.

Emerging Europe’s external financing will be strongly dominated by equity in 2010. Among equity inflows, direct investment will outperform all other capital types and will almost reach its pre-crisis level. This cannot be concluded about banking sector which shows very moderate recovery in 2010 while remaining far behind its pre-crisis level. This is in particular the case for those countries where commercial banks’ loan-to deposit ratio reached more than 100%.

The growing role of emerging economies as capital exporters is clearly seen in the case of China and the US whereas capital flows tend to go uphill – from developing economies to developed economies. The situation in Europe follows a different path whereby capital flows downhill from rich to poor countries, providing the opportunity to boost the region’s growth and consumption. The tighter the integration within Europe the higher the volume of cross-border capital in-flows. This allowed investors and lenders to diversify their financial risks while earning higher yields.

During the pre-crisis period, cheap capital (USD) passed over emerging Europe and market share of foreign banks heavily increased while loan-to deposit ratios skyrocketed. Since credit supply to bank and non-bank sectors in many CEE countries was denominated in foreign currency, this brought greater vulnerability to the region once domestic currencies devalued resulting in a higher rate of non-performing loans.

Although the lending ability of commercial banks is expected to recover in 2010, the volume will likely differ from pre-crisis levels. Stricter regulation on capital requirements has been imposed by the Bank of International Settlements (BIS). Accordingly, the moderate lending activity by commercial banks in order to decrease high loan-to-deposit ratios will not allow for sufficient credit supply to return to the region for at least the next two years. Therefore the region is forecasted to see its strongest debt to equity rotation in 2010 with direct investment expected to double.