I have almost run out of things to say about Japan’s political weaknesses and economic funk, so I will leave you with a selection of what I hope are some of the more informative articles on the country published on this blog.

Why Naoto Kan’t Save Japan (4 June 2010)

Japan’s Debt: Some Unpleasant Questions (10 December 2009)

On The Ground In Greater Tokyo (30 November 2009)

Japan’s Debt: Argentina Times One Hundred! (22 September 2009)

Japan: An Existential Election Victory (1 September 2009)

In Defence Of Economic Stagnation (25 June 2009)

Now Or Never For Japan’s Opposition (15 May 2009)

Japan: Through A Shoji Screen, Darkly (17 February 2009)

Japan: The Strong Yen And The Tourism Impact (26 January 2009)

Japan: The Lost Eternity (30 October 2008)

Japan: The Doors Revolve, But Where Is Superman? (8 September 2008)

The Bad News Bears Go To Japan (15 August 2008)

Japan Aims To Boost Imports… Of People (3 July 2008)

Iraq War: Have The Goals Been Achieved?

First, let me address the Iraq War itself. There were several publicly stated goals by President George W. Bush and/or British Prime Minister Tony Blair in the run-up to the US-led invasion:

• Removing Saddam Hussein and his sons from power
• Democratising Iraq
• Destroying Iraq’s weapons of mass destruction (WMD)
• Destroying the alleged nexus between Iraq and al-Qaeda

There were also several suspected goals which were never claimed by the Bush administration:

• Controlling Iraq’s oil reserves
• Democratising Iraq in the hope that it would democratise the rest of the Middle East
• Developing a permanent US military presence in Iraq from which to project power in the Middle East (especially against Iran, and potentially even Saudi Arabia)

Essentially, at the time of the US invasion of Iraq in 2003, it seemed that the US was hoping to repeat in Iraq what it achieved in Japan during its post-war occupation there (1945-52). That is to say, overthrow the regime, democratise the polity, rebuild the country as the main regional ally, and keep a substantial military presence there. Never mind warnings that Iraq is not Japan.

So overall, were these goals achieved? To quote former Chinese premier Zhou Enlai with reference to the impact of the French Revolution on history, ‘it is too early to say’.

Saddam and his sons are dead, and Iraq has become a democracy of sorts, albeit a very shaky one. Those are certainly key victories for the US. However, the WMD threat appears to have been greatly exaggerated, raising questions about the necessity of the war. In addition, while it is impossible to verify links between Saddam Hussein and al-Qaeda pre-2003, it is certainly the case that Iraq became a safe haven for Islamist militants after the fall of Saddam, as fighters flocked from around the region to wage insurgency there. Furthermore, the cost of bringing Iraq to where it is today has been very high – tens of thousands of Iraqi deaths, 4,400 US troop fatalities (and a few hundred more from the other Coalition members), and considerable damage to Iraq as a nation. Then there is the damage to US prestige caused by the Iraq War.

As for the speculative goals, Iraq’s oil production has yet to return to 2000 levels, due to dilapidated infrastructure, an exodus of skilled personnel, and ongoing tensions between the Baghdad central government and the Kurdistan Regional Government over key oil fields.

Meanwhile, although Iraq has been democratised, the Eastern Europe c.1989-style democratic wave that some neo-conservatives in the US hoped would sweep the Middle East has failed to materialise, and is unlikely to for the foreseeable future.

As for a military permanent presence in Iraq, the US is to keep 50,000 troops there until the end of 2011, officially. As I mentioned recently, I believe that the US will have to keep a sizeable force well beyond 2011, given Iraq’s weak security situation. However, because those troops will have to help the Iraqi military keep the country stable, they will probably not be available for use against Iran (so much for the joke that the US would exit Iraq via Iran!). As for pressuring Saudi Arabia, this seems to have been more of an ideal by ultraconservative commentators in the US rather than an actual policy prescription.

Afghanistan Is The Main War Theatre

Even if Iraq manages to stay reasonably stable from now on, the US is still bogged down in Afghanistan (click here to listen to the BMI podcast on this subject), where it has more than 100,000 troops. In theory, Obama would like to start withdrawing them in 2011 too, but given that the war there is not necessarily developing to the US’ advantage (to paraphrase Japanese Emperor Hirohito at the end of World War II), I suspect that Washington will have to keep the bulk of its troops there for many years to come.

Where Stands The US, Post-Iraq, Post-Recession?

Overall, with the US winding down combat in Iraq, and still stuck in Afghanistan, there are good reasons to believe that it will be cautious about rushing into another war any time soon. That said, a US attack on Iran would differ from the Afghan and Iraq wars, because it would probably consist solely of an air campaign rather than a ground war. Even so, Tehran’s presumed ability to retaliate by making trouble for the US in Afghanistan and Iraq (and possibly elsewhere) is one factor that could restrain Washington for the time being.

The somewhat ambiguous situation in Iraq, the US’ quagmire in Afghanistan, the sharp recession in 2008-2009, and the long-term rise of China and India have all led to suggestions that the US is a declining superpower. ‘Wealth and power are shifting East’ (and to a lesser extent South) is the mantra of the day. Perhaps so, but I offer two counterpoints:

Firstly, we should be cautious about believing that the US is in decline. The US has a tremendous ability to reinvigorate itself.

Secondly, even if the US is indeed in decline, it will probably be the world’s single most-powerful country even 20 years from now. As my colleagues and I mentioned in an October 2008 special report, ‘Why The US Can Remain The World’s Superpower’, the US surpasses all potential peer competitors in most of the six ‘dimensions’ of global power. These are 1) absolute economic power; 2) military force projection capabilities; 3) diplomatic influence; 4) soft power appeal; 5) demographic outlook; and 6) willingness to act globally. China and India, which are the USA’s most plausible rivals, still have a long way to go to catch up with the US in these areas. In addition, China and India both have substantial internal weaknesses which could slow their economic ascent. Furthermore, even if China and India become ‘Great Powers’, they are unlikely to enjoy the kind of global dominance that the US has maintained since the collapse of the USSR. In short, we are moving towards a post-mono-superpower world.

Is Barack Obama The Next Jimmy Carter?

So where does all this leave Barack Obama? His popularity is in decline and many commentators are expecting a Republican victory in the November 2010 mid-term elections. Consequently, Obama is already being portrayed as a potential one-term president, following in the footsteps of George H.W. Bush and Jimmy Carter. (Indeed, earlier this year, Foreign Policy Magazine carried a cover story likening Obama to Carter.) Yet I would caution against writing off Obama. Both Bill Clinton and George W. Bush were at some stage in their first terms perceived as potential one-termers, only to gain re-election when election day came.

Ultimately though, Obama’s fate may not matter that much. The US is greater than any individual leader… but because of this, it will also take more than any single president to turn its fortunes around.

It is likely that the Macondo oil leak in the US Gulf of Mexico (GoM) brought further consolidative pressure to bear on offshore services companies, owing to (perhaps overblown) fears of a thicket of regulation being imposed on deepwater, offshore drilling. Rig providers such as Noble and Rowan struck deals this summer to acquire high-performance rigs. Other service players have been driven by a desire to offer their clients a more comprehensive range of technologies and services. Industry trends driving such acquisitions include greater use of hydraulic fracturing and pressure pumping (shale gas and liquids), deepwater exploration and the development of unconventional resources such as oil sands.

Resource nationalism has driven many countries either to bar industry majors from participating in upstream activity altogether, or to demand unfavourable terms. Majors have little option as their company valuations are driven by their ability to book reserves. In contrast, service companies, as engineering outfits, attract less visibility, and in their capacity as advisors, simply need to win cash contracts to provide technical services and fill specialisation gaps. As their technical capabilities grow, the synergies to be gained from an alliance between state-owned oil companies and service companies are significant.

Trading shares of oilfield services companies is one way to benefit from the long-term bullish trends in crude oil prices (which BMI sees rising to US$90/bbl in 2012) without the volatility of futures trading. Indices such as the Philadelphia Oil Service Sector Index are a route for those seeking this type of portfolio exposure.

However, in the grocery sector the presence of these firms means that the market is highly competitive, which is reflected in operating margins and makes it difficult for any new entrants to penetrate the market. The retail sector has other significant challenges, including the undeveloped nature of the country’s infrastructure, but for retailers outside the grocery sphere Risk Watchdog believes the market remains an attractive investment destination and expects to see a wave of operators entering or expanding their presence in the market.

Brazil Supermarket Sales Index (2003=100)

Dynamic Consumer Market
Brazil’s strong economic rebound from recession has impressed and demonstrated the remarkable resilience of the Brazilian consumer. While retail sales moderated during 2009 (see chart), the indicator remained in positive territory throughout the downturn and the strength of the Brazilian consumer over the last year supports my view that strong private consumption will drive economic growth beyond the current downturn.

Risk Watchdog expects the consumer sector to take an increasingly important role in driving economic growth, as the economy develops and becomes less dependent on the export of commodities. This is represented in Business Monitor’s forecasts for private final consumption, which are expected to outpace the country’s overall economic growth rate. This very strong growth is supported by the rising affluence of middle class consumers and the increasingly positive picture for Brazil’s large low-income population. Government policies to help this section of society, with measures such as increases to national minimum wage, have led to a rapid reduction in extreme poverty and in turn created a larger consumer base for the food, drink and retail sectors.

The opportunities present in Brazil have attracted significant interest, especially in the grocery sector, and the leading retailers continue to expand. Carrefour has announced plans to invest BRL2.5bn (US$1.4bn) in the country over the next two years. Wal-Mart Brazil’s chief executive, Hector Nuñez, revealed that the firm will invest up to BRL2.2bn (US$1.2bn) in 2010 alone. Meanwhile, CBD is newly strengthened following its merger with the country’s largest retailer of durable goods Casas Bahia, and has also announced a massive expansion drive with plans to invest up to BRL5bn (US$2.8bn) between 2010 and 2012, up from the BRL2.9bn it invested between 2007 and 2009. All three have announced plans to focus expansion on the north and north east of the country - an area where grocery retailing is still relatively immature.

Low Margins
This rapid expansion has been good for top-line growth, but with three powerful retailers all competing there has also been significant pressure on prices and margins and it is notable that CBD’s margins are well below both its developed and its emerging market peers. Over the last five years CBD’s margins have hovered around 4% while Tesco and Wal-Mart are both at 6% and emerging market operators in Mexico and Russia regularly report margins above 8% (see chart 2). This can also be attributed to the difficult logistics of the country, with transportation and distribution more expensive.

Operating Profit Margins (%)

Risk Watchdog believes these low margins are likely to put off new entrants into the grocery sector and may partly explain CBD’s recent decision to diversify its operations into durable goods with the acquisition of a 51% stake in Casa Bahia in a non-cash deal and the purchase of a 70% stake in electronics retailer Globex Utilidades in June 2009 for BRL824.5mn (US$422mn). This decision was likely partly driven by the outperformance of the company’s non-food segment during 2009, with the category boosted by government initiatives to aid ownership of white goods by low income families.

Other Sectors More Attractive
This decision reflects Business Monitor’s view that for sectors outside of food and drink the opportunities are likely to be more attractive. In support of this, Starbucks recently announced it was to take full control of its Brazilian operations to expedite expansion, while French Luxury goods group LVMH has said it will be expanding its Sephora business into Brazil with the acquisition of online beauty retailer Sack’s. The firm acquired a 70% controlling stake in Sack’s, representing the firm’s first acquisition in the South American market, reinforcing the growing perceptions that Brazil is well placed to outperform most of its Latin American peers.

While these operators will also be constrained by the country’s infrastructure deficiency, they will at least be operating in sectors where price competition is less intense and margins are more comparable to other global markets. To this end Risk Watchdog sees other international retailers pursuing expansion, with fashion retailer Inditex having already launched around 27 Zara branded outlets in the country. One notable absentee is IKEA, which has already launched in China and Russia but as yet has unveiled no plans to enter Brazil. Here, we come back to logistics, with the country’s underdeveloped ports and road network making the business model harder to develop; yet as the government continues to plough money into the infrastructure sector we expect IKEA to eventually recognise the opportunity and to plough significant funds into the country, where a lack of competition means that homeware is often more expensive than in developed markets and where, from a consumer perspective, the opportunity is undeniable.

Ifo Business Climate Index

In order to answer this question, let’s look at what has been driving the robust performance of the German economy.

1. Germany remains an export-driven economy. The collapse of the euro during the second quarter of the year certainly helped to boost the export competitiveness of German goods to non-eurozone states.
2. Export growth to non-EU states during this period was particularly strong, driven in large part by soaring demand from China.
3. In the eurozone, too, growth surprised to the upside (France grew 0.6% - well above expectations), which given that the bloc still accounts for 60% of German exports, helped to boost order numbers.
4. It also helps that Germany remains a highly productive and competitive economy, with unit labour costs kept down as manufacturers successfully negotiated lower wages with unions during the country’s 4.7% recession in 2009.

Source: Der Spiegel (AP)

Looking at the latter point in particular, we note that a ‘part-time revolution’ of sorts has helped to improve unit labour costs for manufacturers. This has in part been facilitated by the so-called Hartz IV programme introduced under the previous administration of Gerhard Schroeder, in which social benefit payments helped Germans accept lower-income jobs. With little long-term job security to speak of, a record number of West Germans accepted part-time work in 2009. This has certainly allowed employers to be more flexible and re-hire workers quickly when needed.

Part-time workers

Can It Continue?
While fixed investments have been a strong driver of the blockbuster economic growth rate recorded in the second quarter, strong export numbers will need to be sustained to ensure further robust economic growth. This is where the picture becomes less encouraging heading into 2011.

In previous posts and a multitude of podcasts available on this blog, Risk Watchdog and key Business Monitor analysts have warned of the perils of slowing global economic activity as inventory restocking begins to wind down, stimulus measures are withdrawn and overleveraged households continue to painfully rebuild their balance sheets. Add to this the fact that austerity programmes across Europe are being introduced and all of a sudden the much-hyped recovery begins to look less stable than headline growth numbers in Q2 seem to suggest.

While sovereign credit fears will likely continue to dog investor confidence in Europe for the next few years, likely keeping the euro under pressure for the time being, disappointing US macroeconomic data is doing its fair bit to put the US dollar under some pressure of its own.

What is more, even though Germany will remain a European outperformer due to its highly competitive high-quality manufacturing base, faltering external demand cannot be ignored, even if (and that’s a big IF) China continues to grow at a rapid pace. Finally, let’s remember the propensity of German households to save – far exceeding anything seen in other eurozone states. Though a boost to consumer confidence on the back of strong GDP growth may see this unwind briefly, consumer frugality will not be gone for too long. Indeed, wait until Germans are once again asked to dig deep in their pockets to bail out yet another troubled peripheral eurozone economy, which can no longer meet its interest payments on government debt. Surely no one thinks that the European Monetary Union’s structural woes are a thing of the past!

Spread of Irish 10-Year Bond yield over German 10-Year yield, %

At least bond markets don’t seem to suggest that this is the case, and Ireland’s sovereign debt downgrade by Standard & Poor’s on August 24 is a sobering reminder of this. So the answer to our question is a clear ‘no’. Germany’s economic miracle (Wirtschaftswunder) is unsustainable and despite all the positive data, Germans have some very heavy luggage (in the shape of the eurozone) to schlep around for the next few years.

According to the city-state theorists, cities are where all the important economic action is, in terms of business, finance, industry, ideas generation, and innovation. As a result, cities, particularly in developing countries, are becoming ever more connected to the globalised world, leaving much of their host nations behind. Moving between town and countryside is thus becoming more like an international journey.

The bottom line is that many cities are more economically important than many countries. Thus, some social scientists, including Khanna and one of his predecessors, Robert D Kaplan (who wrote a New York Times opinion piece on this very topic at the end of 1999), believe that the world will during the course of the 21st century move back hundreds of years to a time when city states were the norm. I myself adumbrated this possibility in a previous article on this blog, ‘The Perils Of Long-Range Forecasting’.

Closely related to the city-state theory is the Mega-Region theory proposed by Richard Florida in his book Who’s Your City? Florida identifies many mega-regions around the world that are driving the global economy. Among these are Torbuffchester (Toronto-Buffalo-Rochester), Boswash (Boston-New York-Washington), Lon-Leed-Chester (London-Leeds-Manchester), Am-Brus-Twerp (Amsterdam-Brussels-Antwerp), Delhi-Lahore, and Greater Tokyo.

While I do not dispute Khanna’s and Florida’s arguments about the importance of cities and mega-regions as drivers of global economic growth, I have several doubts about the city displacing the nation-state as the principal international actor.

Cities lack military power: First of all, cities cannot completely displace sovereign states as powerful geopolitical actors, because they lack military power. In a world of city-states, cities would still be vulnerable to external attack. Yet how would they respond? After the virtual city-state of New York was attacked on 9/11, it was not the NYPD that invaded Afghanistan, it was the US military. Similarly, let us suppose that a foreign power attempted to seize Brazil’s offshore Tupi oil fields. The putative mega-region of Sao-Rio (Sao Paulo-Rio de Janeiro) would have to rely on the Brazilian military to defend them. At the present time, I do not know of a single city anywhere that has significant military projection powers. Indeed, it is difficult enough for nation states to project power. Even if a city – let us say Sao Paulo – sought to develop its own armed forces, it would surely face opposition from the national capital. This may change in time, but probably not for many decades yet.

Nationalism is still a powerful force: While many cities all over the world have their own distinct cultural identities (whether manifested in an accent, cuisine, niche industry, monument, sports team, TV drama, etc.), and while many global cities have more in common with each other than their hinterlands, I suspect if push came to shove, national identity will trump any identification between fellow global city-states. If anything, the world seems to be experiencing more nationalism than internationalism on a grass-roots basis.

Mega-regions don’t quite exist: Richard Florida identifies many mega-regions in his book, but in truth, I find the concept somewhat exaggerated. From experience, I know that Lon-Leeds-Chester does not exist. Having been on a day trip from London to Leeds a few years ago, I felt no inclination of being in a mega-region. Indeed, there were tens of kilometres of undiluted countryside for significant segments of the train journey. There may well be a region corresponding to Florida’s Lon-Leeds-Chester mega-region, but we tend to call it ‘England’. Similarly, a Canadian friend of mine from Toronto who is well acquainted with Rochester in upstate New York tells me that ‘Torbuffchester’ is an exaggerated concept.

Rural regions still matter a great deal: While cities are undoubtedly drivers of global growth, the countryside can hardly be considered economically marginal. In many emerging markets, the rural regions offer greater opportunities for long-term growth, precisely because they are underdeveloped, although in some cases this will be because new cities are built there or because existing cities absorb their rural hinterlands. In addition, the rural regions have the bulk of agricultural production, and any city-state, no matter how sophisticated, will need at least some basic agricultural hinterland for food security. A city-state entirely dependent on imported food and energy would be vulnerable to a siege.

A world of city-states would not necessarily be safer: Let us suppose that most countries in the world voluntarily dissolved into city-states. This would not necessarily portend peace. In fact, city-states could end up going to war over rural hinterlands previously considered to be the national countryside. Without a national capital as an arbiter, it is unclear how these disputes would be resolved. There would also be a risk that in the absence of a central authority the rural areas between city-states are left un-administered, essentially turning them into lawless ‘Mad Max’-style regions.

Criteria For The Top 10

Employing BMI’s metrics for infrastructure (forecasts and risk ratings), the countries that made it into the final list present a combination of factors including:

• Growth potential and scalability, either in specific sectors, or the infrastructure market as a whole.
• Political support for infrastructure development and government endorsement for public private partnerships (PPPs) and concessions.
• Favourable macroeconomic fundamentals (GDP growth, population and demographic trends).
• Propensity for foreign players to enter the market and a strong competitive landscape.

BMI’s Top 10 Infrastructure Markets*

Australia

Chile

Colombia

India

Indonesia

Panama

Poland

Saudi Arabia

Turkey

United States

*Note: Markets are ranked alphabetically

Some Surprising Absences

There are several notable absences from the top 10, most obviously China, Brazil and Vietnam, but also countries like Qatar, the UAE and South Africa. While BMI maintains core views regarding the significant opportunities and scope for growth in these markets, the Infrastructure Team highlights that there are also risks and uncertainties (unique to each market and of varying degrees of severity) that prevented them from making the final cut.

Why China Fails To Make Final Cut

China’s infrastructure sector is dominated by Chinese state-owned companies and the government has shown a distrust of ownership and operation by non-Chinese, and even non-state controlled entities.

The very high barriers to entry and onerous operational environment mean that the opportunity cost of direct involvement with China’s infrastructure is too high. Essentially, BMI’s view remains that China’s infrastructure industry can currently mainly benefit Chinese players.

Wild West

Ghana has led the way in West Africa, after Anglo-Irish explorer Tullow Oil sparked industry interest with a major oil discovery at the deepwater Jubilee oil field in the Gulf of Guinea in 2007. That discovery has drawn significant investment into Ghana already and looks set to transform the country’s economy once production begins in 2010 and significant exports begin in 2011. If the Jubilee and nearby Tweneboa discovery are both brought online BMI sees production reaching 450,000 barrels per day by 2014.

US explorer Anadarko further heightened interest in West Africa’s oil potential with a significant find at its offshore Venus field in Sierra Leone in September 2009. Since then industry players have set out aggressive exploration programmes off the coasts of Liberia, Côte d’Ivoire and Equatorial Guinea. A planned round to award exploration licences around the small island nation of São Tomé and Príncipe has also attracted significant interest.

Eastern Promise

Tullow again led the way in East Africa with its major 2007 discovery in Lake Albert on Uganda’s western border. The 2bn barrel field has been slower to develop than Ghana’s Jubilee discovery, with production not expected to begin until the end of 2011. Development of Uganda’s oil industry is expected to require US$8-10bn in investment for the construction of production facilities, a refinery and pipelines to send oil to the Kenyan coast, where it can be exported.

Significant interest has spread from Uganda across East Africa, making it one of the industry’s most attractive regions. Much of that interest has focused on East Africa’s significant offshore gas resources, with important discoveries in Mozambique and Tanzania. Kenya is still holding out hope for a major discovery in spite of a recent failure from China’s state-run oil company CNOOC to strike hydrocarbons with its latest well. The truly intrepid have even begun to look to Somalia.

While the resource potential of these frontier markets has attracted great interest from oil and gas explorers, political risks have contributed to a challenging business environment. In Ghana, for example, US explorer Kosmos Energy attempted to sell its minority 30.9% stake in the Jubilee discovery to industry major ExxonMobil. That deal, however, ran into stiff political opposition and in early July 2010 Accra notified Kosmos that it would not approve the sale. The government instead encouraged Kosmos to sell its stake to the state-run oil company Ghana National Petroleum Corporation (GNPC). With Ghana looking to the China Development Bank for funds to develop its oil industry, it has been widely expected that GNPC would eventually sell the stake onto one of China’s state-run oil companies, with CNOOC appearing to be the most likely candidate.

In spite of such political risks, we see the potential rewards in these new frontier markets continuing to attract significant investor interest as explorers seek out opportunities in some of the world’s last largely unexplored frontiers.

The US has been winding down its troop presence in Iraq for many months now, and will have reduced this to 50,000 by the end of August from a peak of 170,000 at the height of the ‘surge’ against the insurgency there in 2007. Under a 2008 agreement with the Iraqi government, those 50,000 are due to depart by the end of 2011. In the meantime, they will train and equip the Iraqi army. The US has already declared an end to combat operations, and Iraq has for some time now been referred to as the ‘forgotten war’ – a label given to Afghanistan in the mid-2000s before that country’s insurgency regained momentum.

Certainly, the relative absence of news from Iraq is good news. However, that doesn’t mean that all is OK there. Terror attacks continue to take place, even after top al-Qaeda operatives in Iraq were killed earlier this year. In addition, Iraq has yet to form a functioning government after the March 7 elections resulted in a deadlock. Furthermore, there is a real risk that sectarian violence between Sunnis and Shi’as, or conflict between Iraqi Kurds and Arabs could flare up again once the US is fully out of the picture.

In view of all this, two public comments by prominent Iraqi officials (past and present) are noteworthy. Iraqi army chief of staff Lt-Gen Babakar Zebari stated last week that the country’s armed forces are not ready to ensure security, and that the US military ought to stay until at least 2020. A few days earlier, Saddam Hussein’s former deputy prime minister Tareq Aziz also criticised the American withdrawal, saying that Iraq was being ‘left to the wolves’.

The best that the US and Iraq can hope for is that violence will dissipate between now and the end of 2011, allowing America to complete its withdrawal as scheduled, and leave a peaceful country behind. Once the US is out, the insurgency will also lose any remaining perceived legitimacy, for the perpetrators will only be able to be seen as terrorists – as opposed to anti-occupation resistance fighters. However, in view of Iraq’s internal weaknesses, I suspect that the current timetable is optimistic.

Indeed, there are two other scenarios to consider. Firstly, the US could fully withdraw in 2011, only for violence to surge in 2012, as General Zebari fears. By that point, it would be politically difficult to redeploy US troops in Iraq, especially in an election year. If Iraq descends into chaos, the US would look bad, especially since the chances are that the Afghan war will still be going strong.

This leads us to what I feel is the most likely scenario: During 2011, violence rises again, prompting the Iraqi and US governments to conclude that a substantial residual US military presence – though perhaps not as many as 50,000 – is still necessary. The scene would thus be set for an extended presence lasting many more years. For how long is difficult to say. General Zebari said 10 years, but the case of South Korea – where the US still has 28,500 troops fifty-seven years after the end of the Korean War – suggests a considerably longer period.

Risk Watchdog believes such concerns are not without grounding, with recent trading seeing the Chilean IGPA and Colombian IGBC equity indices hitting all-time highs, while the Peruvian and Brazilian central banks have been forced to intervene in foreign exchange markets on a near-daily basis in an attempt to stem the ongoing appreciation of their respective currencies. With regional growth set to significantly outperform a host of other emerging and developed markets in 2010 and 2011, and the normalisation of monetary policy likely to boost the carry on offer in many Latin American markets, risks that short-term capital inflows will lead to an even more pronounced appreciation of local currencies loom large.

In my view, there are four key factors which might cause authorities to impose more pronounced capital controls going forward:

1. Recent History/Statements: Risks of capital controls being instituted is greater within those states that have either pursued such measures in the past, or where key policy makers have made recent statements indicating that such policies cannot be ruled out.

On this metric, Brazil, Colombia and Peru stand out as particularly at risk, given Brazil’s recent (October 2009) history and comments by both politicians and central banks in Colombia and Chile.

2. Political Pressures: The risks of capital controls being imposed increases if exporters possess significant political power, particularly when an election is approaching.

Here Peru and Brazil stand out, with authorities in both states set to come under significant political pressure from domestic exporters who are concerned about losing competitiveness over the coming quarters. That the export sectors in both of these states are likely to see a marked deterioration in export revenues through 2011 concomitant with slowing demand from China (a scenario which I do not believe authorities throughout Latin America have adequately considered), will only increase such demands.

3. Composition of Financial Account: The greater the proportion of portfolio inflows (i.e. ‘hot money’) in the financial account, the greater the risk of capital controls being introduced.

As FDI accounts for the lion’s share of financial account inflows in Peru, Chile and Colombia, according to latest balance of payments data, the willingness of authorities to stem the rise of currency appreciation through punitive capital controls is significantly lower (and generally a reflection that any appreciation is being driven by long-term growth potential rather than speculative cash inflows). In Brazil, however, portfolio inflows continue to dominate the financial account, with latest data from the Banco Central do Brazil showing net portfolio investment coming in at US$14.7bn in Q210, compared to only US$3.8bn in FDI and US$3.5bn in other investment.

4. Concerns Over Asset Bubbles: Elevated concerns that foreign capital inflows are feeding into unsustainable asset bubbles increases the risks of authorities imposing controls.

While it is often difficult to ascertain the degree to which domestic policy makers are concerned about potential asset bubbles, fears in Chilean and Colombian financial markets seem to have been growing in recent weeks, as their respective FX and fixed income markets have continued to hit new record highs amidst global headwinds. Although the underlying fundamentals of both economies are certainly sound, policy makers are becoming increasingly concerned about what impact a marked leg down in global risk sentiment could have on capital outflows through the medium term. Should authorities in either state begin to see signs that portfolio inflows are feeding into larger asset bubbles throughout the country, the risks of administrative measures to help redirect the flow of foreign capital into the economy would rise precipitously.

Taken together, this analysis implies that the risks of such measures being introduced are greatest in Brazil and Peru, followed by Colombia, with Chile the least likely to embark on such a path.

Mitigating Scenarios

While risks of more drastic capital controls are rising across the region, there are several mitigating factors. Firstly, monetary policy authorities throughout the region have not as of yet adequately factored in the looming slowdown in external demand in H210 and 2011. As the Chinese, U.S. and eurozone economies experience a pronounced leg down in growth through the latter months of 2010 and 2011, and export revenues begin to fall, the majority of South American currencies should begin to weaken, which would in turn ease pressures on central banks to impose capital controls. While this does not preclude the imposition of such measures, it does imply such policies will be short term in nature, and reversed relatively quickly once growth starts to cool.

Going forward, I expect to see sideways trading for equity markets and in turn oil prices. Indeed, I think oil will likely trade within the wide range of US$70-84/bbl, and do not rule out a break out of this range in either direction, although I hold a downside bias if anything. Oil prices typically remain well supported in Q3 as the US driving season is compounded by increased hurricane activity in the Gulf of Mexico. However, data shows that the driving season has been somewhat lacklustre thus far, and the hurricane season has not yet caused much concern, although it could still pick up in coming months. With these trends in mind, and potential for a downside surprise in China’s growth numbers in coming quarters, I see oil as being highly susceptible to negative changes in risk appetite.

Essentially, China has reiterated its long-standing claims over the whole of the South China Sea, including the Spratly and Paracel islands. Unsurprisingly, this sovereignty assertion is disputed by Brunei, Malaysia, the Philippines, Taiwan, and Vietnam, which each claim part of the islands or the sea (See this link from the US Energy Information Administration for an overview).

In late July, the US entered the fray, saying that it is willing to mediate in the dispute. This greatly angered China, which regards the South China Sea as an internal matter. Indeed, Beijing now views the South China Sea as one of its ‘core interests’ of territorial integrity, alongside Taiwan, Tibet, and Xinjiang province.

Why Is The South China Sea Important?

There are several reasons:

• Critical trade route: Much of the trade between Europe and the Middle East and East Asia passes from the Indian Ocean through the Malacca Strait, then up through the South China Sea to China, South Korea, and Japan. Japanese defence planners in particular don’t want this trade route dominated by China, even though the likelihood of interdiction is remote.
• Oil and gas reserves: Some of the islands are believed to contain significant hydrocarbon resources. Given that most Asian economies import the vast majority of their oil needs, mainly from the Middle East, they naturally wish to tap sources closer to home. The sea also has substantial fish resources.
• Global naval strategy: China is seeking naval preponderance in the South China Sea as part of its bid to become a global naval power. This would include projection capabilities in the Indian Ocean, which is fast becoming a zone of Great Power competition. Japan and South Korea, too, are seeking to strengthen their naval prowess.
  

  South China Sea

What Are The Geopolitical Implications?

The US is clearly trying to deal itself back into South East Asian geopolitics, after a decade of relative neglect by the Bush administration, which focused more on Afghanistan, Iraq, and the wider Middle East. During this time, China stepped up its influence in South East Asia through increased trade, investment, and use of ‘soft’ power. US attempts to bolster its position in the region are evident from its tentative outreach to Myanmar last year, and a planned resumption of cooperation with Indonesia’s Kopassus special forces. Both moves are considered controversial, due to human rights concerns.

However, the real clincher for the US could be its growing ties with Vietnam. The two countries are staging naval exercises this week, and Hanoi could well become Washington’s main ally in South East Asia. This is because Vietnam is arguably the country in the region most concerned about China’s rising power. Not coincidentally, Vietnam was the last sovereign state to be attacked by China, in 1979, and the two are the most active disputants in the South China Sea. China has the upper hand, as evidenced by the fact that in 2008 it forced ExxonMobil to abandon plans to explore for oil off Vietnam’s shore in disputed waters.

A US-Vietnamese alliance would be a strong counterweight to China, and could attract support from Japan, and potentially India. However, there is an inherent danger in building a counter-Chinese alliance, namely it could result in South East Asia being divided into competing camps. This would undermine efforts to build Asian unity through organisations such as ASEAN.

Should I Be Worried About War?

Back in 1997, a British journalist published a future-fiction Tom Clancy-esque novel called Dragon Strike, which portrays a Chinese attack on Vietnam and other regional states in 2001 in order to secure the South China Sea. This prompts US intervention, bringing Beijing and Washington to the brink of nuclear war. This was clearly an alarmist situation, and one that is quite at odds with China’s cautious approach to foreign policy. However, I do not preclude future skirmishes between Chinese and South East Asian vessels, and perhaps even with the US navy if tensions continue to rise.

Recall that it was only as recently as 2001 that China forced down and captured a US spy plane in its vicinity and detained its crew for almost two weeks. Back then, the world’s economy was less dependent on ‘Chimerica’, but were such an incident to replay itself, it would surely send shockwaves through the global financial system, at least in the short term, as investors pondered the future of Sino-US relations.

Even if such skirmishes are avoided, the South China Sea looks set to be another bone of contention between the China and the US, on top of exchange rate reform, trade issues, intellectual property theft, Taiwan, Tibet, and human rights.

Going forward, the key challenge for Beijing and Washington will be ensuring that geopolitical tensions are isolated from economic issues, which necessitate a high degree of cooperation. However, this will not always be easy.

Industry majors such as BP and ExxonMobil, Asian sovereign wealth funds such as Korea Investment Corporation and Temasek, and private equity firm KKR are some of the major investors in US shale assets and companies since late 2008. However, as energy companies began announcing their Q2 2010 financial results, a growing number of gas-focused independents with shale exposure have announced a recalibration of their capital expenditure away from gas and towards oil and natural gas liquids (NGL).

The reasons are twofold:

While gas and oil prices rose substantially during the commodity price bubble of 2008, the post-recession environment has seen a marked divergence. While oil has recovered to the US$70-$80/bbl mark, natural gas prices remain weak. Bearishness has been further entrenched in the market by a glut of LNG supply. As a result, shale investments predicated on a return of bullish gas prices are no longer looking as sound as they did a year ago. Furthermore, concerns have grown over the impact of hydraulic fracturing and other recovery-related techniques on water supplies in exploration areas. In the post-Gulf of Mexico oil spill environment, greater safety regulation can be expected.

The US is the world’s largest natural gas consumer and importer. It consumed 646bn cubic metres (bcm) of gas in 2009, according to the BP Statistical Review of World Energy, June 2010. Owing to the energy-intensive nature of the US economy, BMI currently forecasts LNG imports tripling in the period 2010-20. Although BMI currently forecasts production to remain largely flat over the decade, the development of shale gas might require an upward production forecast revision, and a downward import forecast revision.

From a country risk point of view, corruption has the following negative impacts:

• Corruption (or perceptions thereof) undermines the popularity and legitimacy of governments, especially if the elites are much richer than the general public and are seen to be rich mainly because their privileged positions allow them to acquire wealth through corrupt practices.
• Corruption undermines the reliability of institutions, which in turn undermines investment (both domestic and foreign). Foreign investors seek transparency in the legal system and fair competition for investment contracts. Shadowy non-transparent awarding of contracts is undesirable.
• Corruption can lead to false recording of budgetary revenues and weak tax collection, which in turn undermine countries’ fiscal safety. How can a country avoid crisis if its fiscal deficit is 10% of GDP rather than the officially recorded 2% of GDP? Sooner or later, the truth will out. Fiscal transparency is a major issue right now, given that many countries are running severe budget deficits.
• Corruption may cause international aid to be neutralised, if the bulk of the money is spirited away into the elites’ foreign bank accounts. Indeed, many commentators believe that donor aid can fuel corruption.
• Corruption tends to cause contracts to be allocated to politically well-connected rather than meritorious firms, thus undermining competition and the quality of products/services/infrastructure. In other words, corruption can foster mediocrity.
• Corruption can mean that safety regulations are bypassed. This can lead to shoddy building construction (which later becomes apparent through accidents or natural disasters), or dangerous levels of toxic substances in consumer goods (toys, food, etc, as was the case with many Chinese goods exposed by the Western media in 2007).
• Corruption can lead to essential goods (e.g. grain, food) being hoarded, leading to an artificial spike in prices (and thus inflation). Given that inflation is politically destabilising in any country, this is a potential risk.
• Corruption can undermine security, if the police and military take bribes from drug cartels or well-financed insurgents, or sell weapons on the black market. Criminality in militaries can be a big problem, because it weakens national defence against both external and internal threats. Security is a global issue in the age of terrorism, and the West doesn’t want terrorists infiltrating them or smuggling weapons via corrupt airports.
• Corruption can undermine the education of the labour force, if bribery for grades and university places is the norm. This means that the quality of graduates will be below their ‘official’ standards, making it hard for them to compete in an increasingly globalised world.

That said, there are a few areas where corruption provides some short-term economic benefits:

• Corruption can bypass red tape, thus speeding up investment and business.
• The existence of a black market economy can serve as a vital safety cushion for societies in which the official economy is performing very badly.
• The black market can also provide consumers with goods and services which they might otherwise be denied, much to their dissatisfaction.

Overall, though, I’d say the impact of corruption is highly negative from a country risk point of view. US political scientist Francis Fukuyama may have been wrong about ‘the End of History’, but he subsequently wrote a book called ‘Trust’ (1996) in which he argued that societies with low degrees of trust tend to be less economically successful, because successful economies are highly reliant on trust (e.g. between borrowers and lenders, government and public, producers and suppliers, etc). While his selection of countries may have been questionable, his basic thesis makes sense. Corruption, of course, undermines trust.

The main difficulty for governments in fighting corruption is that many of the elites benefit from the existing system and have no incentive to change it.

I will end on an anecdote. Many years ago, I met a Ukrainian postgraduate student at a leading UK university who was about to finish his course. When I asked him what he was going to do after his studies, he said that he was going to move to Canada. I then asked him if the Ukrainian government (which was partly funding his studies) would not be upset that he would go to Canada instead of returning home, where his knowledge and skills could presumably benefit the economy. His response was that Ukraine’s corrupt elites were quite happy to see people like him stay out of the country, because those who study abroad, educated in ideas such as transparency and clean governance, might challenge the existing elite and try to shake up the system. Perhaps his reply was exaggerated, but it nonetheless underscores how corruption can become so pervasive.

The key policy consequence of weakening short-term growth prospects is likely to be a swifter end to the country’s rate hiking cycle. Brazil’s monetary policy council (COPOM) has already signalled that it is adopting an increasingly dovish bias, and followed up its decision to raise the benchmark Selic rate by a more modest 50 basis points (bps) to 10.75% in July (after two successive 75bps hikes) by insisting that economic growth is now easing towards sustainable levels. With the upcoming release of Q210 GDP data likely to show considerably more modest growth than Q110’s barnstorming 9.0% y-o-y figure, and inflation also on a downward trajectory in recent months, I think the imperative to extend the aggressive monetary policy of recent months is fast beginning to wane.
Market Implications: Interest Rate Futures Down
This more benign inflationary outlook is readily apparent on the overnight interbank deposit (DI) futures market, with the January 2011 contract having fallen 51bps since I first set out my bearish stance on the contract back in mid-July. While I think that the fall is a manifestation of investors’ reassessment of their bullish growth outlook on Latin America’s largest economy, I still believe that the full extent of the slowdown likely in H210 has not yet been priced in. As such, I expect the contract to compress further, and am targeting a move to 10.70% over the coming weeks.

Examples cited include:

• Greater use of foreign actors in American blockbusters
• A reduction of romantic comedies due to foreign audiences not finding the US sense of humour funny
• The production of original films made especially for markets such as South Korea and Brazil

Unsurprisingly, this is being driven – like virtually everything else these days – by shifts in the global economy, i.e., the rise of Emerging Markets. For example, the WSJ article notes that China is planning to open 35,000 cinemas over the next five years, up from only 5,000 at present.

The point about a more diverse cast is an astute one. As far back as the 1960s, Gene Roddenberry, the creator of Star Trek, recognised the importance of having an African, Japanese, Russian, and Scotsman in the crew of the Starship Enterprise. More recently, the highly successful US TV drama Lost had characters from Australia, Britain, France, Iraq, Japan, Korea, Nigeria, and Russia, giving it much greater breadth of narrative than had it been an all-American cast.

What Sort Of Things Might We Expect?

It’s difficult to say, but here are some of my conjectures:

• Perhaps fewer films with a strong US military theme, since this won’t play well in countries critical of US foreign policy. In the immediate aftermath of 9/11, there were rumours that Rambo IV would take Sylvester Stallone back to Afghanistan to fight the Taliban. However, when the fourth Rambo film did finally materialise in 2008, Sly went to Myanmar, a far less controversial destination.
• Related to that point, it will be more difficult to cast global villains. Muslim villains are somewhat taboo these days, and it would be foolhardy for a big film studio to portray China as an evil superpower, since this would risk offending a potential audience of 1.3 billion people.
• More emphasis on global coalitions to save the world from alien invaders. One of my main critiques of Independence Day (1996) was that the fight against the alien invaders was waged solely by the US (with President Bill Pullman personally leading the air armada into battle). In future, China, India, and Brazil will surely be taking part in any interstellar conflagration.
• Perhaps more films with ambiguous endings. Hollywood films usually have a clear-cut good guy/gal triumphs over bad guy/gal conclusion, but in my experience, many Asian films end on a more sober and balanced note, and it’s not uncommon for the protagonist to die in the final scene, sometimes in an act of self-sacrifice.
• Potentially more conservative messages. Many emerging economies, although undergoing rapid social change, are still conservative, and this may necessitate certain themes (including sexual themes) being toned down. Censorship is still more widespread in many of these countries than compared to the West (see this list of notable films banned by China, though it fails to mention Avatar).

Going forward, there are still questions in my mind about whether foreign audiences actually want American films to be tailored to their perceived tastes. Surely one of the appeals of American films is that they are… American? After all, when I go to see a French/Korean/Iranian film, I am going to see it precisely because it is French/Korean/Iranian. This is something in which Hollywood will have to strike a balance. However, foreign film studios will also need to strike a balance between remaining original and just producing local clones of Hollywood-style films, of which there are plenty.

Cemex’s substantial loss can be traced to falling revenues in both Europe and the US. On the other hand, revenues increased in Asia and Mexico, and were flat in the Middle East and Africa. Regional highlights include Egypt, the Philippines and the home market, Mexico. These three countries are high on BMI’s list of anticipated strong performers in terms of construction sector expansion over the next five years. Egypt’s construction industry is booming, fuelled by long-term sustainable demand for infrastructure and housing and the Philippines is a frontier market with a clear focus on substantially raising infrastructure investment and creating the right environment to do so.

Cemex’s relative outperformance in emerging markets illustrates BMI’s long held view that exposure to EM should offset, or at least cushion the blow from developed markets – a view that is especially true in the construction sector, where brief signs of revival in mostly stagnant construction industries due to stimulus packages are now disappearing. This view gives little hope for Europe, which BMI does not expect to contribute much to global construction industry growth over the short term – a view echoed by many construction companies and materials and equipment providers in the industry.

The other interesting point to note is Cemex’s performance in the US. The US is the company’s third-biggest market following the acquisition of Rinker in 2007, which substantially increased its exposure to the US, just as it was about to enter a deep recession in construction activity. Despite a five-year decline (2005-2009) in construction net output, BMI is optimistic that 2010 will be the year the industry returns to growth (2.2% y-o-y real growth projected). The stimulus package should finally start showing fruit in 2010, as construction projects become the key focus. Federal loan mechanisms are successfully leveraging private financing into infrastructure, and residential construction – albeit affordable, government sponsored housing – appears to be emerging from the quagmire of recent years.

Cemex noted some signs of life in demand for certain types of cement from the US. At the same time, some of the world’s largest construction companies (Skanska/Vinci/Ferrovial) are citing opportunities in the US and potential order bookings from the country as a cause for optimism over the next 12 to 18 months. While the US economy appears to be slowing, the construction industry seems to have finally starting showing signs of life.

The wait will soon be over: General Motors (GM) is set to go public on the NYSE during the week of August 16 in what may well prove to be the largest IPO on record. The automaker is hoping to raise upwards of US$20bn in what represents a remarkable turnaround, considering the listing would come barely a year after GM entered – and was quickly bailed out of – bankruptcy protection by the Federal Government. Indeed, the proposed listing serves as the first step towards reducing the US Treasury’s controlling 61% stake in the automaker following its US$50bn bailout by the taxpayer. My view is that given the size of the listing and the firm’s restructuring helping it back onto its feet once again, what was last year considered ‘too big to fail’ may now be too big to ignore for investors.

So, why is GM choosing to go public now? Risk Watchdog believes the reasons are threefold: 1) GM is expecting to report back-to-back quarters of growth for Q2 2010; 2) the US midterm elections are fast approaching; and 3) GM no longer stands at a competitive disadvantage to its market rivals, following its US$3.5bn acquisition of AmeriCredit. Below, I outline the importance of these three factors:

1) The automaker posted its first quarterly profit since 2007 in Q1 2010, and its good form looks set to continue. The newly restructured company’s Q210 earnings report is expected to show a profit for two consecutive quarters, and there is nothing investors love more than healthy balance sheets.

2) The highly-politicised nature of GM’s current status is key to its hopes upon going public. From a financing perspective, while tempting for GM and for the government, the sceptics are right to air their concerns over the firm going public once again. However, on a political level, GM going public makes perfect sense. Risk Watchdog believes that a contributing factor behind GM’s proposed listing is the desire on the part of the Democratic Party to show the electorate that they know what they are doing when it comes to bailouts, and with the wider economy. That said, the government’s decision to dispose of around only a third (20-24%, according to Reuters) of its controlling stake highlights how it is clearly mindful of the repercussions of exiting its investment in the firm all at once. By restricting the supply of GM share on the market, the Treasury is increasing the chances that the automaker’s share price will remain relatively healthy. However, the government remains in a rush to lower its stake in GM to below the 50% mark.

3) Following its takeover, auto-finance firm AmeriCredit will serve as GM’s in-house auto lender. This move provides GM with the freedom to go ahead with the vehicle financing it believes will be most beneficial to its sales, including leasing and sub-prime lending. Indeed, this will come as a welcome break to dealers who have long bemoaned the lack of access to sub-prime borrowers – particularly during times of hardship. The sub-prime market is certainly key to the autos industry, as it is considered less risky than mortgages as vehicles are easier to repossess and the loss is reduced. However, it may well become riskier once again as BMI’s longstanding view of a global slowdown in H210 and into 2011 plays out. In terms of GM’s imminent listing, as GM Chief Financial Officer Chris Liddell noted at the time of the acquisition last month: ‘This is another useful building block in the foundation for an IPO’.

My colleagues at Business Monitor Online recently alluded to this potential in late June. Admittedly, global supply of coffee should improve over the coming months as the bumper Brazilian 2010/11 harvest progresses and as Brazilian exports peak in October. However, despite farmers having passed the half-way point in the 2010/11 harvest, local Arabica prices in Brazil have continued to trend higher in recent weeks. To me, this suggests that current local market tightness may be considerable. Moreover, despite the impending surge in supply, I expect the global market to remain tight on a historical basis. As the market attempts to price in these opposing dynamics, coffee prices could trade in a very volatile fashion.

Other considerations suggest that this volatility could lead to a significant spike in prices. First, the opaque nature of global stockpiles has historically forced the market to rapidly price in underlying tightness once it becomes apparent. This was the case in both 1994 and 1997, when prices exploded higher and nearly tripled over the course of several months. Second, I see room for significant further long positions in the ICE coffee market. While high, net speculative positions remain below the levels seen in 2007-2008. Finally, the technical picture is robust. Currently trading at USc173.05/lb, front-month (September) coffee looks set to post a strong monthly close above the 2008 peak of USc169.60/lb.

Let us consider six dimensions of global power and see how Turkey fares:

• Economic Power: Turkey is already the world’s 17th biggest economy, and in 2007 Goldman Sachs forecast that it would rise to 14th place by 2050. Admittedly, this isn’t such a big leap in rankings, but Turkey will still be a major economy, and for that matter bigger than any Middle Eastern economy. Furthermore, Turkey is already emerging as an investor in many neighbouring economies, and its high level of private consumption means that it could serve as an economic anchor for the region.
• Military Power: Turkey has the second-largest armed forces in NATO after the US, and one of the 10 largest militaries in the world. This gives it considerable strength in the Middle East, where military strength is a high priority. In addition, the Turkish military is considered stronger than most of its neighbours. Furthermore, its military power could increase dramatically if it moves to develop nuclear weapons.
• Diplomatic Influence: As noted, Turkey has become more assertive under Erdogan’s premiership. While Ankara is not a major diplomatic power beyond the Greater Near East, I believe that it can eventually augment its influence by acting in concert with other emerging powers such as Brazil and China. However, Turkey and Brazil’s failure to convince the US-led West of the credibility of its proposal to curb Iran’s nuclear programme demonstrates that much work remains to be done.
• Soft Power: Turkey is not a major ‘soft power’, as evidenced by the fact that its films, TV dramas, popular music, sports personalities, and other fashions aren’t widely recognised beyond its immediate neighbourhood. Nonetheless, this could change over the coming decades. Counting in its favour, Turkey has strong cultural ties with the ‘Turkic world’, which comprises Azerbaijan and Central Asia (which are rich in energy), and parts of Russia. Turkey is also a major tourist destination, and this generally boosts foreigners’ perceptions of the country.
• Demographic Outlook: Turkey’s demographic outlook is strong, and certainly better than most European countries and Russia. The UN forecasts Turkey’s population rising from 76mn in 2010 to 97mn by 2050. Furthermore, the population is youthful, with only 6% aged 65 and above in 2010, rising to a still low 18% in 2050. These factors plus ongoing urbanisation are conducive to robust economic growth.
• Willingness To Act Globally: Finally, Turkey is showing greater willingness to act like a major power – albeit with limitations. By comparison, other states in the region, such as Egypt, appear in a state of geopolitical slumber, and Syria and Iraq are too weak to become major powers. Iran has long been acting assertively, but it is widely regarded as an international pariah.

Location, Location, Location

A further factor boosting Turkey’s importance is its geographic location, which is a critical intersection of Europe, Russia, the Middle East, and North Africa. Very few if any countries in the world have this attribute. Turkey lies right at the heart of a mega-region stretching from the Balkans and Black Sea to the Caucasus, Caspian Sea, and Central Asia, allowing it to serve as a key transit corridor in Eurasia.

Ottoman Empire In 17th Century And Current Influence Vectors

Constraints On Turkey As A Global Power

Despite its manifest strengths, there are still considerable constraints on Turkey becoming a global power:

• Internal Stresses: Turkey is undergoing a major politico-socio-economic transformation, the outcome of which is highly uncertain. Erdogan and his AKP party are pushing Turkey closer to the Middle East as part of a broader domestic agenda that involves a shift away from the country’s secular tradition, but this could eventually lead to a backlash, for it is not universally popular. In addition, Turkey still faces internal stresses over the treatment of its Kurdish population, and if Iraq’s Kurdish north were to become an independent state, this could boost Kurdish separatism in Turkey.
• Possible Western Opposition: While Turkey is reluctant to drift too far away from the US and EU, Ankara could inadvertently end up alienating Western capitals, leading to reduced military cooperation and further European reluctance to admit Turkey into its ranks. In time, this could cost Turkey Western investment.
• Egyptian And Iranian Challengers: As I mentioned, Egypt remains in slumber as President Mubarak nears his end, and Iran remains a pariah. However, Egypt could experience a major revival under a new president, potentially seeking to counter Turkey’s influence in the Middle East. Meanwhile, although Iran and Turkey are currently friendly, Tehran is actively seeking to become the dominant power in the region and could eventually find itself at odds with Ankara.
• Russian Power In Central Asia: Russia is seeking to reassert its influence in Central Asia, while China is slowly encroaching into the region. Both are formidable players and could curb Turkey’s influence there.
• Absence Of Major Naval Projection: Finally, most of the world’s global powers have also been naval powers – e.g. Spain, Portugal, the Netherlands, Britain, France, and the USA. The importance of naval power is recognised by China and India, which are both seeking to build up their navies and expand their influence in the Indian Ocean. However, Turkey is surrounded by inland seas rather than oceans, and its navy, with 50,000 personnel, is the smallest branch of its armed forces, accounting for less than 10% of its troop strength. This could change in time, but it would take many years.

Overall, the scene is set for Turkey to become a major regional power, but with significant constraints.

Bob Dudley is set to take over from Tony Hayward on October 1. BMI’s Head of Oil and Gas Analysis, Holly Pattenden, talks to Gwen Ifill of PBS’ The Newshour about the leadership switch, the company’s liability in the oil disaster, and prospects for survival.

For the markets to have reacted to the upside, the methodology and threshold for passing would have had to come out much more strict than anticipated. What actually happened was that the methodology was revealed to omit major exposures to risk, which clearly suggests that the uncertainty risks priced into equities are likely to linger. Three key omissions:

First, the CEBS made it explicitly clear in its summary report that liquidity risks were not measured. Considering that it was a liquidity crisis above all else which caused the panic in the global banking system after the fall of Lehman Brothers in September 2008, I feel this is a major omission worth noting. As a result, uncertainty over exposures to short-term refinancing across the banking sector and the risks posed by a sudden spike in investor risk aversion will continue to be priced into the market.

Second, the sovereign debt exposures of the banks were only measured against trading portfolios. This means that exposure to the much more substantial amount of treasuries held until maturity in banks’ securities portfolios was not taken into account in the banks’ risk profiles. To be sure, the CEBS made it clear that a sovereign default scenario was not taken into account under this stress test, which would explain why only the trading portfolios were measured. That said, with a restructuring of Greek debt within our core scenario by 2013, I believe that the uncertainty surrounding bank treasury holdings will remain a firm risk.

Third, I note the underlying problem of any stress test, which is the inability to measure unknown risks, liabilities and exposures. By definition, stress tests can only measure known exposures and risks and reveal only that which is already discernible on publicly available balance sheets. As was made evident by the collapse of Lehman Brothers, the biggest risk that can undermine market confidence are unknown liabilities which have previously not been priced in. In the aforementioned case, the uncertainty over credit default swap (CDS) exposures resulting from the collapse of Lehman, which was the counterparty for billions of dollars worth of CDS, resulted in a massive exodus in capital from risky assets.

The company is often considered a bellwether for the construction industry, and indeed industry in general, with equipment used in mining, energy, and a variety of other sectors. Although the initial results indicate an impressive recovery for the construction sector, the results are somewhat distorted by the company’s poor 2009 performance. As production was substantially cut back in 2009, the strong growth reported in 2010 includes considerable base effects and restocking as a result of downsizing in 2009.

The Top And Bottom Lines

Caterpillar posted sales and revenues of US$10.41bn for Q210, rising 31% compared to Q209. The company recorded growth in all regions, owing to a combination of low interest rates and an expected recovery in demand, which has motivated fleet renovations. In addition, the restocking of equipment and machinery – compared to a cut in production implemented in 2009 – was a key driver.

Net profit for Q210 soared by 91% y-o-y to US$707mn. Cost-cutting combined with the growth in revenues have led profits to almost double. For the first half of 2010, net profits reached US$940mn compared to US$259mn in H1 2009. Based on substantial gains in Q210, Caterpillar has increased guidance for its full year results. Sales and revenues are now expected to be within the US$39bn-US$42bn range and the profit outlook has been raised to US$3.15-US$3.85 per share.

Seeing Things In Context

However, the figures are somewhat distorted. When comparing 2010 to 2009, the company’s relative performance in 2009 to 2008 adds clarification. In Q2 2009, sales and revenues fell 41% compared to Q2 2008, while net profit dropped a substantial 66% y-o-y. When looking in value terms, net profit for the first half of 2010 was still down 54% on 2008, when it reached US$2.03bn. In light of this, continued weakness in the global construction industry cannot be denied. Although most countries in the world will post industry growth in 2010, it is a tentative recovery, with underlying weaknesses in a number of markets, leaving them vulnerable to the headwinds of Chinese and US economic slowdowns in H2 2010 and 2011.

Growth in the construction industry is unlikely to return to the pre-2008 highs over the next five years (2010-2014), making 2010 gains a one-off due to 2008/2009 base effects. The headwinds from a slowdown in China are acknowledged by Caterpillar; however, it still indentifies China as that with the single largest opportunity for construction equipment manufacturers in the world. Japan’s Komatsu, the second-largest construction equipment manufacturer in the world, is equally positive about China’s potential; in Komatsu’s FY2009/10 results (April 1 2009 to March 31 2010) the only region (as categorised by the company) to post growth was China, with 15% growth in sales for the 12-month period. The company is ramping up production to meet increased demand from China, showing that Komatsu also believes there is long-term potential for China to be a fundamental driver of revenues.

A recent revision in BMI’s China construction industry forecasts echoes this view, with industry value estimated to have overtaken the US in 2009 to become the largest in the world, and industry growth almost unparalleled. However, BMI is still factoring in a substantial slowdown in the sector, and although growth will still be strong, such incredible gains experienced in 2009 and 2010, we believe, are a thing of the past.

• Grain markets, particularly wheat, are overbought on a short-term basis and look due a temporary breather.

• Nonetheless, the medium-term outlook for grain prices has brightened, in line with the view Business Monitor has been promoting. I have long believed that fundamental dynamics were in place to help grains establish a base and this now appears to be playing out. I would stress though, that grain prices are unlikely to continue trending significantly higher in the coming months. Despite recent crop damage, the global grain market should remain oversupplied over the medium term, which should limit upside for prices. In particular, my colleagues at Business Monitor forecast significant surpluses for wheat and soy over the 2010/11 season.
  

  SPGS Grains Index

• While wheat has grabbed the headlines in recent days, I still prefer corn on a medium-term basis. This is due to corn’s relatively more supportive underlying fundamentals. While soybean and wheat should remain oversupplied, I expect the global corn market to stay tight over the medium term. This is in part due to an expectation that production of corn-based ethanol in the US will remain strong.

• Recent strength in grain markets has bolstered my view that they could outperform industrial commodities such as energy and base metals in the coming months. Cyclically-driven commodities, such as energy and industrial metals, are particularly at risk from an anticipated global economic slowdown in H210 and 2011.

• I have also turned my attention to industry participants who could stand to benefit from a firmer outlook for grain prices. Monsanto looks particularly interesting, as the GM seed producer’s share price has broadly tracked the S&PGS grains index over recent years. With the investors now turning more positive grains, Monsanto could stand to benefit.
  

  Monsanto

The Kremlin’s appointment of Rustem Khamitov, 56, hitherto deputy CEO of RusHydro (Russia’s biggest hydroelectric power company), marks the reassertion of Federal control of Bashkortostan, which along with its neighbor Tatarstan, has long been one of the more independent-minded regions of Russia.

The significance of Bashkortostan and Tatarstan stems from the fact that they are both major oil-producing republics, have sizeable populations, and occupy a key part of Russia linking its European core to its Asian periphery. In the early 1990s, the assertiveness of Tatarstan and Bashkortostan – coming at the same time that Chechnya was seeking independence from Russia – led to fears that the Russian Federation itself might dissolve, like the Soviet Union before it.

As I mentioned earlier this year, the Kremlin has been busy replacing regional leaders, removing Yelstin-era appointees – many of whom have essentially run their own fiefdoms – with new blood. The main reason for this is to strengthen Moscow’s control over the regions, a process began by then-president Vladimir Putin in 2000 and reinforced in 2005 when he abolished elections to regional leadership posts. The second reason is that President Dmitry Medvedev favours introducing new talent so that his plans to modernise Russia’s economy will be enacted at a regional and not just a federal level.

As well as Rakhimov, the presidents of Karelia (which borders Finland) and Chuvashia (which lies west of Tatarstan) have also stepped down. All eyes are now turning to Moscow’s long-serving mayor, Yuri Luzhkov, whose term expires in 2011 but could be cut short like Rakhimov’s presidency. Despite its assertiveness, the Kremlin must still be sensitive to local sentiment when appointing new leaders, in case it alienates these regions through ill-considered choices.

While the Kremlin has reasserted its control over key republics and territories, it seems to be losing its grip on the North Caucasus, where an Islamist insurgency has been plaguing Chechnya, Ingushetia, Dagestan, and Kabardino-Balkaria, and where the Circassian peoples are mobilising to draw international attention to their past suffering at Imperial Russian hands. Indeed, the North Caucasus will remain a troubled region for many years to come and could prove the Kremlin’s biggest domestic headache.

A series of marketing plans, aimed specifically at major emerging markets including India, China and Vietnam in Asia as well as Brazil and South Africa, are the main tools utilised by Obama in boosting exports. US trade representatives are also lobbying hard for the removal of trade barriers on exports to the above markets, and will aim to increase the international exposure of specific markets and industries. Although Obama has declared the first few months of the NEI a ‘terrific’ success, a record US$17.7bn deficit with China in June suggests otherwise.

The measures taken by the US to boost exports are in contrast to the approach adopted by Canada, a neighbour of the US and a rival exporter of goods such as grain, iron ore and coal to Asia. In June, Canada’s largest port, the port of Vancouver, inked a supply-chain collaboration agreement with rail freight operator Canadian National Railroad (CN). The agreement aims to improve the efficiency of the supply chain, which should increase the competiveness of the port as a major export hub.

In BMI’s view, the ‘grass roots’ approach being taken by Canadian operators to increase export revenues further underlines the failure of the Obama administration to challenge one of the major obstacles to growth: the inadequacies of US trade infrastructure. An overreliance on its services sector as a major source of export revenue has left the US with a heavy deficit in traded goods, leaving the freight transport sector geared heavily towards imports. According to UNCTAD (the United Nations Conference on Trade and Development), in 2007, about 4% of the global merchant shipping fleet was flagged to the US, weighing about 12.4mn deadweight tonnes (DWT). The percentage of US-registered vessels in the 1950s, in contrast, averaged about 40%. Meanwhile, the US’s west coast ports, although among the world’s largest in terms of throughput capacity, are primarily catered towards imports and thus, in BMI’s view, are ill equipped to handle a sudden spike in outgoing cargo.

Across the border, in Vancouver, Canada boasts North America’s largest coal terminal, making it well placed to take advantage of growing shortfalls in China and India. US shippers are able to export through Vancouver, but at some stage a designated US terminal will be needed to handle increasing export demand over the next few years.

Canada also holds a natural logistical advantage over the US in terms of its capacity to export grain to Asian markets. Its main growing regions are situated to the west of the country, providing a direct supply route from Pacific coast ports, between 16 and 18 days sailing time from China’s eastern seaboard. In contrast, US exports, which are produced in the Midwest plains, are traditionally shipped from Gulf coast ports, with a sailing time to China of between 33 and 37 days.

With Obama seemingly paying little attention to these fundamental imbalances, it remains to be seen whether expensive marketing initiatives alone coupled with favourable macroeconomic conditions will allow the US to meet its ambitious trade targets by 2015.

 
The major problem in Spain is that over the past twenty years, the whole banking system became ever more reliant on the construction and real estate sectors. To put this in context, back in 1991, credit outstanding for construction projects and real estate activities constituted 30% of total loans. Now that figure stands at 60%, and the sectors have already begun to deflate. Housing prices have fallen by 12% according to government statistics, but this isn’t close to what the eventual contraction will look like considering that there is a supply glut of more than one million properties in Spain. On top of that, when you factor in that household and private sector leverage has now reached an unprecedented 200% of GDP and unemployment is now the worst in the eurozone at 20%, the perilous situation facing the banks becomes a little more apparent.

Housing & Construction Loans

Don’t Forget, Spain Is Due A Painful Internal Devaluation

The consumption boom isn’t coming back anytime soon and so the economy now needs to rebalance away from domestic demand and more toward external consumption. However, in order to achieve this, Spain will need to make significant productivity and competitiveness gains. As risk watchdog has previously been saying, as a member of the eurozone, Spain can’t achieve this task by way of a nominal currency devaluation and instead is being driven down the internal devaluation route, whereby domestic wages and prices are forced downwards. That is only going to make matters worse for the banks. So where does this leave us?

Regional Unemployment Rates

Whither Spanish Banks?

Well, banks can certainly expect more of their loans to go bad over the next 12-24 months owing to unprecedented headwinds facing the economy. In turn, provisioning by banks will need to rise, squeezing net profit margins further. Stagnancy will likely become the order of the day. All this is a long way of saying that the age of easy credit in Spain is now over. Banks are going to have to focus on “smarter” lending practices, and the smaller savings banks, or Cajas, will need to push forward with their restructuring and consolidation process. For now, the sector looks like it can continue functioning given the relatively benign levels of leverage within the banks themselves, the promise of support from the government, and the continuation of ECB liquidity. One thing is for sure though: a systemic crisis in the Spanish banking sector would completely overshadow events in Greece.

Most notably, Dagong rates 18 countries lower than the international agencies, and these are Canada, Netherlands, Germany, USA, UK, France, Belgium, Spain, Israel, Italy, UAE, Thailand, Mexico, Romania, Iceland, Greece, Philippines, and Ecuador.

As for countries it rates higher than the main agencies, these are China, Saudi Arabia, Russia, Brazil, India, Indonesia, Venezuela, Nigeria, and Argentina. Geopolitically-minded readers will immediately notice that most of the above are non-Western states that Beijing is seeking to cultivate as allies to counterbalance the power of the West or are key providers of commodities for China’s rapid growth.

This raises questions about the whether Dagong is ideologically motivated or biased in some way, and whether it is reliable in its assessment. (The rest of the countries it rates are in line with the main agencies.)

The Real Story Is An Alternative Discourse

My take on Dagong’s motivations and reliability is that it doesn’t actually matter that much. What I mean is that the big three credit ratings agencies have been severely discredited by the global financial crisis, and they are typically way behind the curve. Therefore, Dagong won’t necessarily do a worse job, and there is certainly room for a new ratings player (for that matter, Business Monitor International publishes its own sovereign risk ratings every quarter, available to read on Business Monitor Online and in our weekly Emerging Markets Monitor magazine).

Dagong is certainly right that most Western countries face tremendous fiscal risks, and these are likely to remain considerable due to aging populations. As for whether Dagong is ideologically motivated… well who, pray (besides BMI), is not ideologically motivated?!

A key question is how influential Dagong’s ratings will be in determining whether China’s cash-rich big firms invest in the 50 rated countries. If Chinese firms afford more attention to Dagong than to Moody’s, S&P, and Fitch, then clearly Dagong will carry significant weight. However, it is unlikely that Western firms will abandon the big three agencies any time soon. Also, given that Chinese firms will surely want to invest in Western countries, Dagong will probably be reluctant to downgrade them too far.

The broader point about Dagong’s sovereign risks report is that it offers an alternative discourse in a world that is still largely dominated by Western institutions such as the IMF, World Bank, G-7, NATO, etc, and by Western media such as CNN, BBC, the New York Times, Financial Times, Newsweek, etc. Over the coming decades, as China (and other big nations) rises even further in economic importance, we will eventually see a new and probably non-Western discourse emerge, and we had better get used to it.

• In the event of a continued improvement in risk appetite over the coming days, Brent Crude and Base Metals are best placed to head higher.

• However, with regard to the medium-term picture, commodity markets are being pulled in opposite directions by countervailing forces. On the one hand, a strong rebound in consumption figures for industrial commodities points to a robust cyclical recovery. On the other hand, capital markets suggest a far bleaker outlook.

• With several bearish factors aligning in recent weeks, I see a significant risk of a bearish trend change in commodity markets.

Reuters-Jefferies CRB Index

First, while the short-term picture shows some promise, weekly and monthly charts for commodity markets urge caution. Equity markets looks similarly precarious. Second, fixed income markets in a number of developed states (Australia, Germany, US) are increasingly pricing in an extended low-interest rate, low-growth environment. Third, some commodity currencies such as the Aussie dollar look toppy. Most importantly, should Business Monitor’s key macroeconomic convictions play out in the coming months, the cyclical rebound could be derailed. BMI calls for a slowdown in US economic activity as we move into 2011, and significant macroeconomic headwinds in China. Taking these factors into account, despite potential for a continued bounce in the coming days, I am increasingly cautious commodities in the medium term.

While overcapacity was the main problem threatening the sector this time last year, with the oversupply of box ships dragging down container shipping rates, this year has been marked by shortages, particularly those of equipment, with lines faced with a lack of containers.

The problem stems from last year, when decreasing demand in the box shipping sector on the back of a global decline in trade prompted shipping lines to stop replenishing their container stocks. Slackening demand led to a number of containers being sold for scrap or finding a new role in the construction sector. Bizarrely, a Travelodge hotel in the UK made entirely of shipping containers opened in 2008.

A lack of replenishment has led to problems for the container shipping community in 2010. Volumes have surged year on year (y-o-y) as inventories were re-stocked in the first half of the year. BMI expects container shortages to continue as we head into peak season.

Lines are tackling the container shortfall with a policy of surcharges, a strategy that shippers have condemned as a revenue drive tactic.

BMI believes the companies that will benefit from this container crisis are – unsurprisingly – the container manufacturers. Most are based in Asia, with China dominating the field. The top two companies in this industry are CIMC Group and Singamas. Singamas is already starting to feel the effect of the strengthening demand for containers, with the company posting a positive profit warning and its order-book full until the end of September. To better illustrate the turnaround in this companies’ fortunes, Singamas estimates that it is producing 65,000 20-foot equivalent units (TEU) per month: an incredible recovery considering that the company produced just 86,600TEU boxes in the whole of 2009.

With volumes surging and containers in short supply, a recovery is indeed afoot. BMI, however, errs on the side of caution, noting that the recovery is from a low base and demand volumes of 2008 are still some way off. On top of this, BMI’s sluggish consumer growth predictions for both the US and eurozone indicate that the demand boom will peter out.

Notable public sector healthcare projects in emerging markets include:

• Mexico’s Seguro Popular social insurance system, which reimburses treatment in all cases where ‘catastrophic’ costs were likely to be incurred. Key beneficiaries are those on low incomes and people living in rural areas.
• Russia’s DLO (Dopolnitelnoe Lekarstvennoe Obespechenie) scheme, which covers medicine costs for certain pensioners, war veterans and low-income families in a bid to improve their level of healthcare.
• China’s CNY850bn (US$125bn) healthcare reform programme, which will widen insurance coverage to include many more of its vast rural population, as well as to build thousands of community healthcare centres over the next three years.

Private Healthcare Spending As A Percentage Of Total Healthcate Expenditure In A Selection Of Emerging Markets

However, it is important to note that not all emerging markets are following this trend, and private sector spending is still increasing in absolute terms. Using data from the World Health Organization (WHO), BMI has looked at expenditure on medical services for the six main emerging markets: China, India, Turkey Brazil, Russia, and Mexico. With the exception of Turkey, all countries are forecast to see a decline in private healthcare spending as a percentage of total healthcare expenditure through to 2018.

Private Healthcare Spending As A Percentage Of Total Healthcate Expenditure In A Selection Of Emerging Markets

It is significant to note that this is a recent trend. If BMI had used WHO data from 1998-2001 in our forecast model rather than numbers from 2005-2008, five of the six countries would see an increase in private healthcare spending as a percentage of total healthcare expenditure over the medium term. Exposing the fallibility of forecasting, Turkey would be again the exception to the trend.

Exchange Rate - US$/EUR & RSI (bottom)

So how is it that with all the ongoing concerns about Europe’s sovereign credit worthiness, worrying signals in global fixed income markets, and the prospect for a painful internal devaluation of the least competitive eurozone economies (namely the PIIGS), the currency is now rallying? Well, before answering this question, I suggest we identify what has been driving this recent bounce of the euro, which up until early June still looked like it would hit US$1.16/EUR!

• Firstly, let’s remember that speculative short positions on the euro went through the roof in Q1-Q2, hitting a record over 160,000 contracts at one point in mid-May, shortly before the euro hit its recent trough.

• Daily momentum indicators, such as the relative strength index (RSI) began to head into record oversold territory (see chart above) during this period, signalling to investors that the currency may be due for a bounce soon.

Euro FX Non-Commerical Contracts/Futures Only

And bounce it did!

Let’s also remember the host of poor poor economic data coming out of the US at the end of June, ranging from shocking new home sales numbers – now that government stimuli are being withdrawn – to a very bad outlook for the US labour market. This hardly augurs well for the US dollar, and has therefore seen the greenback begin to slide. So, combine technical unwinds of euro shorts, catalysed by bad US fundamentals and you have a recipe for a big correction.

Does this mean that the euro’s troubles are now a thing of the past? Certainly not, if you ask this dog! Ask most analysts out there and they will tell you that Greece is still set to default (or restructure as some prefer to call it), and Spain’s housing bubble is increasingly becoming ripe for a major correction.

I would therefore caution against premature optimism, and note that my colleagues at BMI are still wary of the potential negative impact another sell-off in the euro could have on some of the more favoured European currencies, such as the Polish zloty and Turkish lira. So while the euro may have further to go for the time being, the fundamental picture for the eurozone remains a poor one. We believe that beyond an unwinding of speculative short positions in recent weeks, all that has happened is that the easily bored financial investor has shifted his/her attention to economic events in the US. That’s all.

US 10-Year Treasury Yield, %

But a closer look at the yield curve is disquieting, even to Risk Watchdog, as the US and German 2s-10s curves look set to come down considerably after being elevated for two years.

Germany Spread of 10 Over 2-Year Bunds (%)

Such a flattening could realistically occur under two scenarios. First, if central banks tighten rates, raising short-end yields, otherwise known as a bearish flattening. Or second, if short-end yields remain constant (and at 0.6% or so, 2-year yields have little room to fall), while the long end comes down considerably. Given my macro outlook (and that of my colleagues at Business Monitor), I think the second scenario is more likely by far. It would coincide with further significant equity downside, and perhaps even a cranking up of quantitative easing. Either way, it is a warning signal.

US Spread of 10 Over 2-Year Treasuries (%)

As expected, the act tightened restrictions against Iranian commercial transactions with the outside world and increased penalties for proscribed deals such as those relating to its nuclear programme and energy sector. The US government intends to prohibit transfers of credit or payment between any financial institutions either based in or dealing with Iran, and maintains an almost-total ban on imports and exports between the two countries. The act requires asset freezes on any individuals affiliated with any Iranian government organisation, including the powerful Iranian Revolutionary Guard Corps (IRGC). The act also calls on the president to consider imposing direct sanctions on the Central Bank of Iran, or any third-party financial institution dealing with it.

As regards the energy sector, the act applies a penalty on organisations that invest more than US$20mn in projects to develop Iran’s oil and gas resources. In addition, the act targets investors in Iran’s refined petroleum products segment with sanctions, if the investment’s fair-market value exceeds US$1mn, and also applies sanctions to exporters of refined petroleum products into Iran, should the products’ fair-market value exceed US$1mn. Furthermore, the act also calls on the president to submit to Congress, within 90 days, a list of all international energy-related ventures with Iranian participation, targeting any foreign investments that have been even partially financed with Iranian money. Finally, the legislation mentions Iranian imports of ethanol, which Tehran had been hoping to source from Brazil to reduce its gasoline vulnerability.

Companies have responded to the US, EU and UN sanctions by halting gasoline exports to Iran, halting crude oil imports from Iran and pulling out of energy development projects, such as the South Pars gas field. Furthermore, the UAE – the most important regional transshipment and commercial centre – has instructed local financial institutions to freeze bank accounts linked to Iranians targeted by the UN sanctions.

Nonetheless, Iran’s large proven oil and gas reserves (10% and 16% of the world’s total, respectively) will continue to attract industry attention. BMI’s Oil and Gas Team believes that Russian and Asian companies are best placed to take advantage of the vacuum created by the departure of their Western counterparts. Having said that, they run the risk of penalties should they need to access the US or EU financial system in any manner. Iranian plans to develop its energy reserves depend on its ability to continue exploiting legal and commercial loopholes. While the sanctions have the ability to affect both of these channels, their success will be determined by the comprehensiveness of their application.

BMI’s Oil And Gas Head Interviewed On NPR Radio

Meanwhile, Business Monitor International’s Head of Oil and Gas Analysis, Holly Pattenden, spoke on The Morning Edition of US National Public Radio on July 1 about the future prospects of BP CEO Tony Hayward in light of the Gulf of Mexico oil spill and the likely candidates to succeed him. The interview can be found by clicking here.

• The technical picture across equity and commodity markets continues to look weak, while bond markets are increasingly bullish.

• Global economic fundamentals will continue to weaken in H210, with downside risks.

• Combined, these dynamics could signal a trend reversal, particularly if key commodity markets fail to push above their 50-and 200-day moving averages in coming weeks.

Equity markets are weaker this morning on the back of the revision to China’s leading indicator, with Asian markets down sharply, and US markets likely to follow when they open. As my colleagues at Business Monitor have been flagging up, the short-term rally in US equities has been running out of steam. The dow failed to break above the 50-day moving average, and is currently trading below its 200-day moving average. Furthermore, momentum indicators look weak, with the MACD turning lower (crossing the signal line) below the zero line. As such, I do not rule out a break below trendline support around the 10,000 level, which would be a bearish technical signal. Moreover, fixed income markets have seen yields compress across the curve, which suggests that bond markets are pricing in a sustained period of weak economic growth and possibly deflation. In particular, I highlight the Australian 10-Year government bond, the yield on which has collapsed to 5.14% from 5.40% in recent weeks. This is of particular importance given the strong trade links between China and commodity exporters such as Australia, Brazil, Canada and Russia to name but a few, which have been the main beneficiaries of the reflation of commodity prices since March 2009.

Moreover, the dry bulk shipping sector and hence the Baltic Dry Index is suffering from the twin forces of falling demand and an oversupply of ships which looks set to come to a head in H210. From a demand perspective, the major concern for ship owners has been a notable retrenchment in Chinese imports of the two main materials involved in steel production - iron ore and coking coal - which fell in both April and May on the back of retreating demand from the country’s property and construction sectors.

At the risk of sounding like a broken record, I continue to highlight that commodities such as energy and metals will be most affected by falling equity markets and slower growth in China. As such, I anticipate sideways trade for energy markets, with risks of a downside break. From a technical perspective, front-month Brent Crude is struggling to push above its moving averages, and this could see a move back to trendline support around the US$70.00/bbl area, particularly if the number of miles driven in the current US driving season surprises on the downside. Furthermore, in the event of a large correction, this would likely see the MACD turn lower back into negative territory which would be bearish.

With all the discussion about the sustainability of currency unions lately, I thought it would be appropriate to see how developments in the eurozone and elsewhere were impacting Africa. Although few people may realise it, there are no less than 14 West African economies sharing a common currency, the CFA franc, which is in turn pegged to the euro. In fact, their exchange rates have been pegged to a European currency (French franc prior to the euro) for over fifty years, during which time the CFA franc has only been devalued once. However, with fears arising over the future of the euro, legitimate questions have been raised about whether the currency of the West African Economic and Monetary Union (WAEMU) is also in danger of coming unravelled. Here I point to some basic reasons why I think it will be held:

• The prevailing economic situation in Africa is considerably stronger than at the time of the last devaluation (in 1994), with GDP growth rates forecast to recover fairly strongly from the downturn of 2009.

• Likewise, the current account balances of the WAEMU countries are much better than in 1994, when many countries were clearly suffering from the effects of an overvalued exchange rate.

• The nominal anchor provided by the peg to the euro has been such that inflation rates have remained at very low levels by African standards. The only countries on the sub-continent that can claim equally low rates of inflation are in Central Africa, where the local currency is also tied to the euro. While the WAEMU lacks many of the other features of an optimal currency area (OCA) – free flow of goods, labour mobility, and centralised fiscal authority – the benefit provided by price stability still outweighs the economic costs of adopting a ‘one size fits all’ monetary and exchange rate policy.

To this view, I would introduce two main caveats: First, the gain in competitiveness provided by the 1994 devaluation is slowly being eroded. The pace of economic reform has been slowing since 2004, and the resulting loss of competitiveness could increase pressure for another devaluation down the road. Second, consumer prices began to decouple from those in Europe owing to higher average food prices. To the extent that this trend feeds into higher labour costs, it could further hamper the region’s ability to offer low priced goods for export.

US President Barack Obama’s decision to replace General Stanley McChrystal as commander in Afghanistan raises the question of how the war effort there is likely to proceed under new commander General David Petraeus.  BMI’s Tim Cooper talks to Yoel Sano, Head of Political Risk, about the future of Afghanistan.

Mumbai is constantly changing and Aasim, my driver and part-time guide, was quick to point out the new developments: a high rise set of apartment buildings; a half-constructed overpass; a new addition to the already cramped skyline.

Unlike my taxi, Mumbai is a town on the move. It is one of the fastest growing cities on the planet, having grown from 10 million people in 1991 to 18 million. The McKinsey Global Institute Report forecasts the population to reach a massive 33 million by 2030, approximately four times that of Greater London today.

Urban Infrastructure Poses A Challenge, To Say The Least

Traffic congestion is just one of the problems caused by its over-expansion. The city is clogged with people of all walks of life, many of them flooding in from the countryside all over India as the country undergoes a quick and chaotic process of urbanisation. Aasim is one of these migrants. He is aged 30 with a wife and young child and has come from a village in the state of Orissa (North East India) to Mumbai. He plans to work for a few years, earn good money, and then return with ‘enough for everything we need’. Aasim does not want to stay in Mumbai any longer than he has to. Life expectancy of Mumbaikers is low, he tells me; just 57 – around seven years lower than that of other Indians. The pollution takes its toll. Ranked among the 10 most polluted cities in the world, a day walking around the city is said to inflict the same damage as smoking two and a half packets of cigarettes (although how this is calculated I have no idea!). Ten per cent of people in the most polluted areas suffer from asthma.

The pavements are just as chaotic as the roads, with street hawkers selling juice and cigarettes, families camped out on pavements, people rushing by, others lingering; there seems to be too many people with too little space. One vendor was selling an array of books, magazines and newspapers. A headline in India’s main financial daily screams ‘Congested Mumbai to choke further’ and highlights the city’s ‘overstretched’ water supply and transportation services. That the infrastructure requires development and money has not gone unnoticed or ignored: the Indian government recently promised US$500 billion over the next few years. There are opportunities aplenty for developers and construction and engineering firms. My trip from the airport to hotel the previous evening took me over a new eight-lane bridge which has reduced time from the town’s upmaket Bandra district to Worli from 40 to just seven minutes. A new monorail network is due to open in 2011.

A Walk Through Dharavi

Despite the government’s efforts, however, for the moment Mumbai is still chaotic. And yet, in a strange, haphazard way, it works. Everywhere there are signs of industry, entrepreneurship and growth. Aasim drove me into the town’s sprawling slum, Dharavi, home to one million people and famed for its depiction in Danny Boyle’s Slumdog Millionaire. Aasim pointed out a shop front, laden with empty water bottles and spilling with bags of neat strips of plastic. This is a bottle recycling store, he told me. People take in used containers in exchange for a rupee (about one and a half pence). Everywhere I stepped there were clay pots baking in the sun, ready for sale in the city’s markets. Down the narrow alleys, there were men producing everything from fabrics and clothes to metals and oil. Dharavi is home to an estimated 15,000 single-room factories, each no more than a few square feet in size.

This is a billion dollar economy, my guide told me. It’s a big sum, though it equates to little over £700 per person a year. For all its endeavours, Dharavi is desperately poor. Conditions, though improving, are still a far, far cry from the terraced apartment blocks of the city’s richer districts barely a kilometre down the road. There is just one toilet per 15,000 residents, no public hospital, and only a handful of municipal schools. Furthermore, open sewers filled with human and industrial waste leave residents prone to a cocktail of diseases including cholera, typhoid, and malaria.

Things are changing. The city’s authorities, embarrassed into action by the publicity from the 2008 Oscar winner, have hatched plans to relocate some 57,000 families to a 30 million square foot new development across the city. Out of sight; out of mind. The 40% of Mumbai’s residents estimated to be living in unofficial housing highlight the scale of India’s urban poverty, interfering with the nation’s image as a modern, growing economy: a BRIC nation ready to assert itself on the global stage. The slum’s population have been opponents of the scheme, however, preferring to remain in their homes, free from government interference and bureaucracy.

Winners And Losers

En route home, Aasim took me via the smart Breach Candy area and Altamount Road where Mukesh Ambani is building his billion-dollar skyscraper home. Ambani, one of the richest men in the world having inherited Reliance, India’s largest private company, is harnessing the combined flashiness of all of Bollywood in the 27-storey home that will boast 400,000 square feet of living area, six floors of parking space, and three helicopter pads.

Ambani is one of the winners from India’s growth story. With forecast GDP growth of around 8% in 2010, India battled through the economic downturn relatively unscathed. Yet, rapid growth comes at a cost. With inflation currently running at around 10% y-o-y and food price inflation soaring above 20% after recent droughts, the Reserve Bank of India has unleashed a series of money tightening measures since January to cool fears that the economy is overheating. Most recently, the Reverse Repo Rate was raised to 3.75% with banks required to hold more cash in reserve. Further action is expected at the July monetary policy meeting.

Returning towards South Mumbai, back to the Gateway of India, the landing place for British governors and other distinguished personages in a bygone era, my attention was caught by yet more street vendors.

From a scruffy man sitting with charcoal burning at his side I bought some roasted peanuts, served in used fax paper. I asked him where it’s good to get a drink. He wobbled his head, beamed at me, and pointed across the road to the five-star Taj Palace Hotel and says, ‘It’s very good there’.

Indeed, looking at the PIIGS in particular (Portugal, Ireland, Italy, Greece and Spain), I remain convinced that a painful deflationary cycle in these economies remains on the cards. My conviction is primarily based on the assumption that Southern eurozone economies (and Ireland) cannot exercise independent monetary policy, and will therefore need to undergo extensive internal devaluations to restore economic competitiveness. This has already been highlighted by sharply rising unemployment rates and falling output levels, and reaffirms Risk Watchdog’s belief that the eurozone economy will be a global underperformer in real GDP growth over the next few years!

Having been able to borrow at ECB rates for years, these economies have racked up household and public sector leverage, driving asset prices and wages higher, and ultimately eroding the competitiveness of their domestic economies. The PIIGS are now at a substantial disadvantage to compete on a global scale, at a time when external demand remains fragile to macroeconomic headwinds and wide scale deleveraging is well underway.

Euro Weakness Not Enough
Despite the over 18% drop in the value of the euro against the US dollar since November, this has done little to improve the competitiveness of PIIGS economies, which to a large extent rely heavily on eurozone demand for growth. In stark contrast, Germany’s economy, which was already extremely competitive to begin with, has benefitted immensely from the weaker euro, and will likely continue to do so.

Exchange Rate - US$/EUR

My colleagues at Business Monitor have taken a look at the Harmonised Competitive Indicators (HCI) compiled by the Bundesbank, which is an index based on consumer price inflation and bilateral trade flows (including with other eurozone members). This serves as a good gauge of competitiveness in the eurozone. The accompanying chart shows how PIIGS economies remain highly uncompetitive vis-à-vis their German counterpart, which in a weak global demand context augurs poorly for their future growth outlook. Indeed, the superior competitiveness of the German economy has been remarkable for the past decade (see chart), highlighting the higher labour costs and wages in the smaller economies since euro adoption.

HCI

Meanwhile, the weaker euro has immensely helped to boost Germany’s competitiveness, by driving the HCI lower (see chart). To be sure, Germany has been well placed to benefit from euro weakness, having maintained an HCI below 100 for most of the previous decade.

In contrast, however, the sharp correction in the euro since the Greek sovereign debt crisis has hardly seen the Greek HCI move lower, which remained well above 107 in April. Greece’s economy has lost in competitiveness as the euro grew in strength, but so far has failed to regain any of it during the recent drop in the euro’s value against the dollar.

The Baltic Experience: Leading The Way
Given this dislocation of the value of the exchange rate (euro) and competitiveness of the PIIGS economies (i.e. labour costs and consumer prices), an internal devaluation is inescapable at this point. Indeed, the three Baltic economies of Estonia, Lithuania and Latvia are a case in point, having been undergoing painful internal devaluations since 2009. Fixed exchange rate regimes (ERM2) and a withdrawal of easy credit have led to sharp contractions in output and wages in recent quarters, as the economies seek to restore some level of competitiveness through a debt deflationary cycle.

Nominal Hourly Labour Costs Q110, % chg y-o-y

In recent quarters, nominal hourly labour costs in the Baltic three have fallen sharply, with Lithuania experiencing an 11.0% year-on-year (y-o-y) contraction in the first quarter of 2010. Latvia’s nominal hourly labour costs fell 7.2% y-o-y, while Estonia’s dropped 5.5% during this period. Meanwhile, both Portugal and Spain experienced nominal hourly wage growth of 0.3% y-o-y and 2.0% y-o-y, respectively in Q110, and the euro area (EA16) saw nominal wages rise 2.1% y-o-y during this period.

This will likely change going forward – though union action and weak coalition governments may cause some delays. In particular, labour markets are set to loosen further over the medium term, with the situation having already taken a decisive turn for the worse in several PIIGS economies. This will put additional downside pressure on wages.

Unemployment Rate, %

Looking at the construction sector, there are already seeing signs of housing bubbles being deflated. During the first quarter of 2010, Greece’s construction sector shrank by 19.7% y-o-y, and Spain saw construction output fall 12.9% y-o-y during this period.

Construction Output Q110, % chg y-o-y

Though a long way off the +40% y-o-y contractions seen in Latvia and Lithuania (see chart), I do not rule out the possibility of the decline in construction output gathering pace over the coming quarters, but most notably highlight that the ongoing deflationary spiral in the housing market - particularly in Spain and Greece - will likely persist over the medium term. Concomitantly, Risk Watchdog believes that a drop in nominal hourly labour costs will also be forthcoming as both private and public sector wage levels currently do not match macroeconomic reality - even with the euro being below US$1.2300/US$. Ouch!

Source: UK National Archives

In keeping with its promise to deliver an emergency budget within 50 days of coming to office, the UK’s Conservative-Liberal Democrat coalition government today unveiled a painful package of fiscal reforms to get public finances back on an even keel. Delivered by Chancellor of the Exchequer George Osborne before parliament, the budget proved to be particularly radical, but largely expected.

Lambasting fiscal profligacy at the hands of the previous Labour government, Osborne stressed the necessity of the budget to maintain foreign investor confidence and the need to spread the burden evenly. In addition, citing empirical research that fiscal consolidations focused on spending cuts were more successful and beneficial for growth, the Chancellor informed parliament that the budget will focus on budget cuts over tax increases in ratio of 77:23.

The government used today’s budget speech to highlight the forecasts from the recently inaugurated interim Office for Budget Responsibility (iOBR), which now handles the fiscal and economic projections which will be used in formulating specific policies. In particular, public sector net borrowing (PSNB) is forecast to retrench to £20bn (1.1% of GDP) in 2015 from £149bn (10.1% of GDP) in 2010, while the structural budget will be balanced by 2016. The iOBR, which is also mandated to assess the government’s ability to satisfy explicit targets, stated that the Tory-Lib Dem alliance is on track and will meet its objectives of a balanced budget one year ahead of schedule.

Below I highlight some of the main features of the emergency budget.

• Public sector wages will be frozen for two years. Those earning under £21,000 (1.7mn workers, 28% of the public sector workforce) will be protected. All workers will receive a flat £250 increase in 2010 and 2011, which will have a higher proportional impact on lower earners.
• Increase the state pension age to 66.
• Abolish Health Pregnancy Grant.
• Child benefit will be frozen for three years.
• Medical assessments will be required for new and existing claimants of the Disability Living Allowance (DLA).
• Housing benefits will be curtailed.
• The corporate tax rate will fall to 24% from 28% over four years, with Osborne triumphantly declaring “Britain is open for business”.
• Firms outside of London which employ at least 10 workers will be exempt from up to £5,000 in national insurance contributions.
• As expected, value added tax (VAT) will be raised to 20.0% from 17.5%. This proved the most contentious proposal in parliament, with the sudden uproar forcing the Chancellor to stand down for the only time during his speech.
• Food, children’s clothing and books will still be exempt from VAT.
• No changes to duties on alcohol, tobacco and fuel have been proposed.
• Labour’s decision to increase cider tax by 10% has been reversed, delighting West Country voters.
• For higher earners, capital gains tax (CGT) will rise from 18% to 28% as of midnight tonight, with the CGT allowance remaining at £10,100.
• For the under 65s, the taxable allowance on income will rise from £6,475 to £7,475 in April.
• For local authorities that can keep spending growth under control, the government will help them to freeze council tax.
• A new levy will be imposed on banks which is expected to raise £2bn from 2011 and will partly offset the benefit of lower corporation tax.
• From April 2011, basic state pensions will be re-linked to earnings.
• In April 2011, the child element of the Child Tax Credit will increase by £150 above CPI indexation and by £60 above indexation in April 2012.

Labour’s response to these measures proved particularly scathing, with acting leader Harriet Harman proclaiming the budget was “reckless” and would not spread the burden of adjustment fairly, falling on the old adage “same old Tories”. However, Harman did indicate that the Labour Party will support the hike in CGT, bank levy and personal allowance increase.

On the whole Risk Watchdog thinks it was a fairly extensive budget that will help restore the health of the UK’s public finances. While acknowledging the need to limit the dependence on debt-fuelled consumption and rebalancing the economy more towards exports, BMI is still wary of the proposed VAT increase which could hit the pockets of the many consumers who travel from across the world to spend money in British shops. It remains to be seen whether the government can credibly commit to this program, though one thing is for sure: public protests and worker strikes are looming on the horizon.

• Good For Growth: With the removal of political uncertainty and the continuation of market friendly policies introduced by President Álvaro Uribe set to remain in place for the next five years, the country stands to benefit from strong capital inflows going forward. Moreover, Santos’ plans for fiscal consolidation, with a balanced budget by 2014, places the country back on track to achieving a ratings upgrade to investment status in the near future, in my view.

• Security Improvements To Continue:A centre-right congress places former defense minister Santos in a strong position to continue Uribe’s fight against the insurgent Fuerzas Armadas Revolucionarias de Colombia (FARC). Strong security measures will assist Santos in achieving his other important campaign pledges, including labour market reform, the reduction of corruption and increase of educational standards, as the government reins in control of the peripheral regions of the country.

• Positive For The Peso: In recent days I have turned increasingly bullish the peso, given the positive outlook for Colombia’s investment climate and economy in general. With the election now firmly sealed in Santos’ favour, and the COP/US$ exchange rate sitting at key resistance, at COP1,932/US$, a break through this level in the next few days would support my bullish outlook for the currency. Moving to the stock market, although it is difficult to assess the impact of the vote on the benchmark IGBC equity index, due to the heavy weighting of several leading companies (for example Ecopetrol carries a 28% weighting) in the index, Santos’ victory is likely to be largely positive for Colombian equities.

This positive step puts Colombia firmly at odds with Argentina and Venezuela, which I have long identified as regional weak links given the high level of government interference in the economy. Certainly, there is little to suggest that any significant improvement in macroeconomic policy making is on the cards ahead of respective parliamentary and presidential elections in 2011 (Argentina) and 2012 (Venezuela) – indeed, in Venezuela’s case things could be set to deteriorate significantly in the short term – and unless these votes produce more market-minded administrations, Argentina and Venezuela are set to be left trailing behind more business-friendly economies over the medium term.

• The announcement is a political manoeuvre, most probably designed to soothe US anger over the yuan’s stasis over the past two years, and placate the world’s major economies ahead of the G-20 meeting in Toronto this coming weekend.
• There is no guarantee that the yuan will actually appreciate by any significant magnitude. The PBoC’s statement says in its final paragraph that the exchange rate will be kept ‘basically stable’ to achieve ‘macroeconomic and financial stability’. Although the PBoC’s language on the global and Chinese economies was upbeat, my colleagues and I believe that China’s recent economic performance is unsustainable, and will see a slowdown in the second half of 2010 and 2011. In fact, BMI does not rule out a recession in China. A stronger yuan would probably hasten this process.
• As such, my colleagues and I point out that ‘flexibility’ is not a one-way bet. Indeed, if the PBoC had issued the same statement in December 2009, we would have expected a modest depreciation (say 2-3%) over the past six months. I do not expect this now, but the point is that the yuan is not a one-way currency, as is almost universally believed.
• Given the shaky state of the global economy, and the increasing likelihood of a second half slowdown, the PBoC is unlikely to let the yuan appreciate significantly.
• The trade-weighted yuan is already back to where it was in late 2008, when exports were falling sharply. With inflation rising and wage pressures mounting, the real effective exchange rate is also strengthening to a dangerously high level.
• Capital inflows could indeed accelerate after the PBoC’s announcement, but these could be offset by China’s negative real interest rates.

• In the long term, it certainly makes sense to expect the yuan to appreciate, especially as China seeks to rebalance its economy away from exports in favour of greater private consumption. However, this is a multi-year (and possibly multi-decade) phenomenon, and those expecting major yuan gains this year or even next are likely to be disappointed.

My colleagues in the Africa team at BMI are equally excited by the prospects for private consumption growth over the coming years. The continent’s population is expected to reach 2 billion by 2040 and BMI’s Africa desk sees GDP per capita growing at a rapid clip as strong headline economic growth trickles down. Throw in the fact that the African consumer is coming from a low base (as a rough proxy, average mobile phone penetration stood at 46.3% in 18 Sub-Saharan African countries that BMI covered in 2009) and the prospects do look very compelling.

These are not lost on global firms: sticking with the telecoms example, there has been a dash for assets in the industry, the latest example being Bharti Airtel’s purchase of Zain’s African assets. Furthermore, beer giant SABMiller has invested heavily in its subsidiaries across the continent, believing firmly in the long-term potential on offer.

It would be foolish, however, to wax lyrical about the opportunities without being cognisant of the risks. Political instability, although improved from previous decades when civil wars ravaged countries from Mozambique to Uganda and Angola, still remains common. Basic infrastructure remains woefully inadequate in many countries, meaning that distribution of goods and services is expensive and difficult. Furthermore, the fact remains that most Africans are poor and spend the majority of their incomes on food rather than goods. As such, a sustained spike in food prices would significantly reduce disposable income, delaying the rise of the African consumer.

Also, Riskwatchdog is not one of those who see the entire continent as a single market and I acknowledge that consumer tastes and preferences will vary from country to country and from sub-region to sub-region. But the point that the continent as a whole is the final frontier in terms of growth potential and that the consumer will play a very large part in this story cannot be denied.

• The cocoa market will likely to remain volatile and I do not rule out continued gains in the coming weeks towards GBP3,000/tonne. However, I expect prices to be lower in 2011 and as a result, see potential for a cyclical peak in prices in H210.

• Sugar presents impressive potential for a short-term rally, although I expect prices to grind lower over the medium term.

• While potentially overdone on a short-term basis, the medium-term outlook for coffee prices has firmed markedly.

I continue to anticipate a moderation in cocoa prices as we move into 2011. However, given the volatile nature of cocoa prices, the timing of such a pullback is difficult to predict. I expect that the pickup in grindings that traditionally occurs in Q3 and Q4 will keep pressure on global stocks. Therefore, it is unlikely that market tightness will be noticeably relieved until Q410/Q111, when cocoa arrivals at ports in Côte d’Ivoire begin to flood in. I expect the global supply outlook to improve gradually from this point. Indeed, my colleagues at BMI forecast global cocoa production to outstrip consumption in the 2010/11 season for the first time since 2005/06. In my view, this should encourage a moderation in global cocoa prices and as a result, I see potential for a peak in cocoa prices in H210.

Meanwhile, front-month (July) sugar could bounce strongly in the short term. The contract has continued to edge higher in recent trading and has broken above key resistance in the USc16.00/lb area. A weekly close above USc16.00/lb would further improve the technical picture and open the door for a more pronounced bounce towards the USc18.00/lb area. The global sugar market remains tight on a historical basis and therefore, a tentative uptick in global imports has the potential to catalyse a bounce in prices. However, despite potential for a short-term rally, I expect a steady improvement in global supply of sugar to encourage a gradual drift down towards multi-year support which currently comes in around the USc12.00/lb area.

Front-month (July) Arabica coffee has exploded higher in recent trading and the medium-term outlook is increasing bullish. Calling short-term moves in this sort of market is somewhat of a lottery. Nonetheless, the recent break higher has markedly firmed the medium-term outlook for coffee prices. In particular, it has bolstered my view that market tightness will underpin coffee prices in the coming months. This is despite the scheduled surge in supply of beans from Brazil that should accompany the 2010/11 ‘up’ year in the country’s biennial coffee cycle as it progresses.

Data shows that the construction industry has considerably outperformed the economy in general over the past five years, with average real growth in industry value of 10.8% per year between 2005 and 2009, compared to 3.7% GDP growth over the same period. Indeed, when the economy entered recession in 2009, construction industry growth peaked at 7.9%, and was an important force in pulling the country out of recession.

Investment plans reached ZAR28bn (US$3.6bn), and included allocations for airports and other transport infrastructure, stadia, telecoms and broadcasting, and other logistical elements of hosting the World Cup. However, this did not include investment carried out by Eskom to ensure that there is power to light up the games (a very real concern less than two years ago), the Gautrain (South Africa’s much lauded ‘high speed rail line’), or countless other investments into road and rail projects. The true value of preparing for the World Cup may never be known.

What is clear is that some may feel the investment was not worthwhile. The gleaming new stadia stand in stark contrast to South Africa’s large slums, and the recurring labour strikes illustrate discontent by the wider population. Many question whether the money would have been better spent on easing the considerable poverty that is rife in South Africa. This question will only grow once the tournament is over, and the stadia lie empty. Beijing’s Olympic Bird’s Nest Stadium has done the same for China, and a similar fate could be in store for the next World Cup host, Brazil – a country also battling with abject poverty.

Attention Turning To Brazil 2014 And 2016

With the 2010 World Cup under way, attention will soon turn to Brazil. The country is in equal need of infrastructure upgrades and FIFA has already raised concerns over the timely construction of stadia and airports, the areas which require the most attention. Moreover, with Brazil hosting both the World Cup (2014) and the Olympics (2016 in Rio) in quick succession, the country has a rare opportunity to showcase its potential and maximise long-term economic benefits.

Brazil has already allocated US$11bn for the World Cup and US$14bn for the Olympics. This is substantially more than South Africa, but with a construction industry more than seven times the latter’s size, the impact is likely to be more moderate. For the 2010-2014 period, when the majority of the investment will take place, BMI’s infrastructure team is forecasting average real growth of 7% per year for construction industry value.

But before Rio hosts the Olympics, London will host the games in 2012. BMI expects only a limited boost to the construction industry from the UK’s preparations, with much of the crucial infrastructure for catering to an influx of people already in place. The main investments will be on the Olympic venues and village. A further reason for a cautious outlook is the UK’s financial position, which allows for limited frivolous spending, especially with a new, fiscally conservative government in place.

So, all this is excellent news, right?

Alas, not necessarily.

Having US$1 trillion of minerals in your soil is one thing, but being able to extract it is quite another. Just ask North Korea, which is estimated to have a hyperventilating US$5.94 trillion worth of minerals. As with Korea, there are good reasons to believe that Afghanistan will not be in a position to benefit from its mineral wealth for many years to come. Consider the following:

• Afghanistan remains in a state of war. While it could be argued that all factions have an interest in peace so that they can reap the benefits of mineral investment, it can be argued equally strongly that they will all intensify the war so that they can claim the biggest share of the pie. Not only that, but new conflicts could emerge between the central and regional governments over the spoils.
• Even if the Afghans tire of war, the fact is that all these minerals will be coveted by China, India, Pakistan, Iran, Russia, and Western countries. Afghanistan has been a cockpit of great power interests for generations, and the struggle for dominance over these resources could mean that external powers prolong the war through proxies. China has already emerged as Afghanistan’s biggest foreign investor, committing US$3bn to the Aynak copper mine. Meanwhile, the US has almost 100,000 troops in Afghanistan, and although Barack Obama seeks to start withdrawing them from 2011, the vast resources on offer suggest that the US has a good reason to keep a substantial military presence for many more years. Indeed, comparisons between Afghanistan and the remote planet Pandora featured in the James Cameron blockbuster Avatar are bound to increase.
• Conflict aside, Afghanistan’s infrastructure (both in terms of mining and transportation) will take a long time to get up to scratch. Because Afghanistan is landlocked, ports in Pakistan and Iran would be the most logical outlets to world markets, but neither of these countries inspires much confidence to investors, and probably won’t for some time.
• Even if mines can be built and metals transported abroad, corruption could keep revenues from benefiting the state coffers and the general public. Afghanistan’s Karzai administration has been accused of being highly corrupt, and there is no reason to expect a quick improvement.
• Furthermore, the pollution caused by mining could become highly problematic. Toxic waste, if dumped carelessly, could cause illnesses which could mobilise locals against foreign mining interests – whether Western or otherwise.
• In sum, even if Afghanistan were to become a major commodity exporter, it would not necessarily become prosperous. Rather, it could end up suffering from the ‘commodity curse’ whereby dependency on minerals obviates the desire to create value-added industries.

I apologise for sounding somewhat pessimistic. However, if I am wrong, and Afghanistan and North Korea are able to prosper from their mineral wealth, then three letters of the BLANK group of countries I proposed a while back will start to draw investor attention, leaving Burma and Laos behind.

What we have witnessed is an unprecedented event: never before has a deal of this size (US$35bn) been brought crashing down to its knees by dissenting shareholders. While the immediate cost of the botched takeover attempt – which came to GBP450mn – may have fuelled calls from shareholders for a purge of the boardroom, it is the qualitative impact of the deal’s failure that I believe will be wider reaching.

Perhaps the most significant implication of the failed acquisition is the increasingly active role of shareholders. While shareholder dissatisfaction with large-scale takeovers is not uncommon, as we saw with Royal Bank of Scotland’s convoluted takeover of Dutch lender ABN Amro back in 2007, for investors to halt such a mammoth acquisition is certainly a striking development.

As shareholders wake up to the increasingly important role they have to play in corporate governance, it serves to remind boardrooms of two things:

1) that they are becoming increasingly accountable

2) in terms of deals: biggest isn’t always best.

I believe that shareholders are beginning to act in the same way as sovereign wealth funds (SWFs) in dealmaking. Both are becoming increasingly active in their roles. While SWFs have started seeking seats on boards and more voting shares, key shareholders are starting to provide checks and balances upon the activity of their executives using their own voting rights.

Interestingly, both SWFs and private shareholders are doing it for the same reasons: to enjoy more upside from their investments. In light of this development, Prudential is no doubt rueing its decision to make its move for AIA without first ensuring the backing of its key shareholders.

The scuppered deal also serves to highlight the dangers of cross-border M&A and how market volatility is eating into M&As’ already sluggish rebound so far in 2010. While I still hold the view that cross-border deal making will continue to take a larger percentage share of overall M&A in the short-to medium term, the Prudential deal certainly serves to heighten the downside risks to this view, as it highlights just how hard a cross-border deal can be to ink.

This is because cross-border deals require approval in multiple jurisdictions where regulations can often differ greatly. In terms of market volatility, it seems that BMI’s long-held view that global growth is set to slow in the second half of 2010 and in 2011 is becoming increasingly salient. This will undoubtedly put downside pressure on M&A, giving dealmakers yet another headache to contend with. Indeed, against the backdrop of volatile markets and a continued spike in risk aversion on the part of investors, the Pru’s failed bid for AIA is unlikely to be the last high-profile transaction to fall foul of completion. Moreover, in the year to date, global withdrawn M&A already stands at US$135bn, according to BarCap data.

My attention has recently been drawn to increasing reports of kinks and bottlenecks springing up across the global supply chain. In Brazil and Australia, the largest suppliers of iron ore to the Chinese market, road and port congestion has long been accepted as part and parcel of the rise in export growth over the past few years. However, the 44% y-o-y growth in China’s iron ore imports in 2009 brought reports of delays and bottlenecks at major export terminals to unprecedented levels.

In Brazil’s case, the recent difficulties have been underpinned by decades of underinvestment in the country’s transport infrastructure. Though ranked a respectable 41st (out of 155 countries) in the International Bank of Reconstruction and Development (IBRD)/World Bank Logistics Performance Index (LPI), the growing demands of the country’s trade needs have placed considerable strain on its freight transport sector, and, in particular its largest maritime facility, the port of Santos, which despite challenging economic headwinds, in 2009 achieved a record throughput of 83.2mn tonnes.

The under-capacity of Brazil’s port sector is no secret: the National Agency of Maritime Transport (Antaq) is forecasting throughput to reach 1.2bn tonnes per year by 2023, an increase of about 85% on 2008 levels. At present, shippers are overly reliant on Santos to transport goods in and out of the country, with about 25% of total exports estimated to pass through the facility.

The largest port in Latin America with a capacity of just over 80mn tonnes, Santos, just outside Sao Paulo, stands alone as Brazil’s only ‘world class’ maritime facility. Brazil’s next largest port is Paranaguá, which has a capacity of about 40mn tonnes. When compared with China’s port sector, the difference is staggering: China has no less than ten ports able to handle more than 100mn tonnes a year. The two largest facilities, Shanghai and Ningbo, each handled more than 500mn tonnes in 2008 – more than six times the volumes seen at Santos.

As the upward trend in Brazil’s export volumes has continued into 2010, the kinks in Brazil’s supply chain have become more apparent. And it’s not just ports feeling the strain; a bumper grains harvest has led to increasing reports of congestion and bottlenecks along the highways leading from the country’s agricultural heartland to the coast.

Worryingly, in terms of its logistical development, Brazil can be considered to be a regional outperformer. If Brazil’s LPI ranking is flattering, so are those of other major South American states, namely Argentina (ranked 48^th), Peru (67), Colombia (76) and Venezuela (84).

At least Brazil can rely on a relatively stable macroeconomic and political environment, though this has not always been the case. Next door, it has been Argentina’s turn to suffer the historically Brazilian diseases of high inflation (CPI is forecast to hit 21% in 2010) and fiscal mismanagement. The freight transport sector has borne the brunt of increasing public unrest and a series of strikes and road blockades have taken place in protest against the decreasing real pay levels of dockworkers and the excessive export tariffs imposed on agricultural producers.

Of course, when it comes to mismanagement, neither country can come close to matching the exemplary efforts of the Venezuelan government and one Hugo Chávez. Having brought several regionally-managed ports under federal control in March 2009, the port sector has fallen into disarray and, in May 2010, dockworkers warned that the country’s largest maritime facility, Puerto Cabello, was three months away from complete collapse.

The obstacles thrown up by South America’s freight transport sector present perhaps an extreme case: other parts of the developing world including the Middle East, and East and South East Asia generally boast a higher level of transport infrastructure development. However, the problems facing shippers to and from Brazil and its neighbours are not confined to the region and are also common among developed states, most notably Australia. Taken together, the logistical constraints of the developed and developing world are expected to provide one of the major challenges to long-term growth in global trade.

From a technical perspective, gold remains in its broad uptrend and has recently hit a new high of US$1,252/oz. While I would not rule out a move back to support around the US$1,150-1,200/oz area on a short-term basis, I remain upbeat with regard to gold prices and continue to target a move to the US$1,300/oz area. Risks of a sovereign crisis in the Eurozone have not dissipated, and potential for a sharp slowdown for the global economy in H210 has contributed to uncertainty.

Gold has outperformed the dow in recent weeks, and I see potential for this trend to continue. The Dow-Gold ratio, broke below 13-month support around 9.4x in early May to trade at 8.2x at the time of writing. I believe that this is indicative of recent shift in investor appetite from risky assets towards perceived safe havens. From a technical perspective, the push below the 8.5x area could set up additional downside towards the March 2009 low of 7.1x. While we are not there yet, it is likely that persistent sovereign debt concerns, combined with financial market turbulence would compress the ratio further, in line with the ratio’s 10-year secular trend.

Furthermore, I have also been highlighting the breakdown in the relative value play between platinum and palladium. Back in Q109, I suggested that palladium would outperform platinum, and this view played out with the Platinum to Palladium ratio moving in palladium’s favour until recently. However, in mid May, I highlighted that the relative value trade could be reversing, with platinum becoming the outperforming metal. Moreover, with this in mind, I expect gold to outperform both platinum and palladium over the short term.

My colleagues in BMI’s telecoms team are watching developments closely, for the investment decisions made here and now will affect the industry and its key players for the rest of the decade. Our industry forecasts and core views are being revised to reflect these trends.

Insufficient Capacity Necessitates Overhaul

While mobile phone users can already access the internet, send and receive emails and watch streamed video content over 3G networks, there are now so many of us doing all these things that the networks simply cannot cope with the demands being placed on them.

More than one billion mobile phones were sold around the world in 2009, of which approximately 15% were smartphones, according to market leader Nokia. Meanwhile, there were nearly four billion mobile subscribers (many customers buy a new phone every year). Smartphones are expected to account for around one third of sales by 2014, further adding to the pressure on mobile networks.

But it doesn’t stop there… With wireless technology increasingly being embedded in all kinds of non-telecoms devices – think eReaders, laptops/netbooks, gaming consoles and satellite navigation devices – capacity is in short supply.

What Are The Options?

Two competing technology standards are available to operators looking to make the move to 4G. WiMAX got a head start and has been employed as both a fixed and a mobile broadband platform, but limitations with regards to mobility and the fact that it cannot be grafted onto existing 3G networks mean it has already been relegated to the role of a low-cost wireless access system for rural and remote areas. LTE (Long Term Evolution) represents a more obvious migration path from existing 3G systems, and is therefore now receiving the full attention of the world’s largest operators.

TeliaSonera was the first to launch a commercial LTE network, covering both Sweden and Norway, at the end of 2009, but it has yet to attract many users, possibly due to a lack of handsets and a lack of an obvious ‘killer application’ above and beyond what is already available on 3G.

But 4G is now arriving elsewhere. Verizon Wireless will launch a service later in 2010 aimed at mobile computer users in the US. Rivals AT&T and MetroPCS will follow suit in 2011. In Asia, the Singapore Telecom group is to use LTE for operations in Australia, Indonesia and Singapore. Other operators will follow in their wake. Equipment vendor Nokia Siemens Networks (NSN) claims to have 30 operators trialling its LTE equipment, around half of which will certainly progress to commercial operation.

However, selling 4G may be a tricky proposition and the BMI telecoms team believes that, as speed is at the heart of the 3G issue, the emphasis should be placed on the very high data throughput rates, rather than trying to sell 4G as a discrete product.

• A fiscal deficit of around 10% of GDP
• A public debt burden of 200% of GDP
• An ageing and shrinking population
• Weak private consumption
• Consumer price deflation
• A weak external environment, with a real possibility that China – Japan’s biggest trade partner – could slow sharply.

Given the sheer scope of these problems, no Japanese leader, no matter how capable, can be expected to make progress in tackling these any time soon. Most likely, it would take at least 5-10 years to put Japan on the path to sustained recovery. However, the temporal dynamics of Japanese politics do not allow prime ministers that much time.

Revolving Door Premiers Hobble Leadership

Kan is Japan’s fifth prime minister in four years, and the thirteenth since 1990. As far as I can tell, Japan has the world’s fastest turnover of heads-of-government. No wonder that they have been referred to as ‘revolving door’ prime ministers (alas, with no Superman in sight). Indeed, the political system has a chronic inability to produce strong and durable leaders. The main exception to this pattern was Junichiro Koizumi (2001-2006), who presided over a strong period of economic growth supported by a robust global economy. This allowed the government to trim back its budget deficit and stabilise its debt burden. However, with the economy souring thereafter, successive premiers have come a cropper very quickly.

Essentially, Japan’s political culture makes it virtually impossible for prime ministers to hold onto office if their approval ratings drop below 25%. And, given the economic challenges I listed above, it is virtually inevitable that the incumbent prime minister’s popularity will slide below 25% within a year of taking office. Kan’s immediate political test will come in late July, when Upper House elections are held. A poor performance by his Democratic Party of Japan would severely weaken his leadership.

Thus, I see very little scope for Japan to break the cycle of revolving door prime ministers. This means that real power will continue to be wielded largely behind the scenes by party heavyweights and the bureaucratic machinery, with the latter generally being averse to political and economic reform. Yet without such reforms, Japan will find itself unable to reverse its seemingly irreversible decline.

Meanwhile, the rapid turnover of Japanese premiers leads to policy confusion for voters and investors alike. With each successive premier reshuffling cabinet posts and consolidating his authority, this means that a considerable amount of political capital is spent on jockeying for position rather than meeting the challenges at hand.

Fiscal Consolidation Becoming Urgent

Kan’s top priority will be bringing about fiscal consolidation, lest investors conclude that Japan will eventually experience a fiscal or debt crisis. However, striking a balance between cutting spending and raising taxes will be difficult, since this could tip the economy back into recession just as it appears to be recovering.

China Purchasing Managers

I would like to remind readers that Beijing’s CNY7.5bn loan quota for 2010 is already 45% accounted for with data only out up to April, which means much tighter monetary conditions over the coming months. Should the property bubble burst aggressively as a result, sending house prices in the major cities down 30%, it is not difficult to imagine a situation where construction spending falls by a similar amount. Construction spending in the US is currently down 30% from its peak after a similar decline in home prices, and the ‘house prices never fall’ mentality that drove the construction boom in the US appears every bit as visible in China today, which I take as a worrying signal.

Regional Investment Booms

The accompanying chart shows how China’s current investment boom compares with others we have seen throughout the region, namely Thailand and Malaysia in the 1990s and Japan in the 1980s. While the true rate of expansion may be exaggerated by Beijing’s unique accounting methods, the boom is clear for all to see, and the historical precedents are a cause of major concern. 

]]> http://www.riskwatchdog.com/2010/06/02/expecting-a-recession-in-china/feed/ http://www.riskwatchdog.com/2010/06/01/gm-corn-ucopia-in-africa/ http://www.riskwatchdog.com/2010/06/01/gm-corn-ucopia-in-africa/#comments Tue, 01 Jun 2010 16:27:50 +0000 http://www.riskwatchdog.com/?p=1307 Read more...]]]> There will be two important growth drivers for this: Biofuels and livestock. As alternative energies become more popular, corn (which is used to create bio-ethanol in the US and some other countries) production will require increases, particularly since some governments (notably South Africa) have already implemented plans for increased bio-fuel content in gasoline.

Another important growth driver will be poultry production, which uses corn as feed. As poultry production increases to meet rising demand - owing to increasing incomes in emerging markets - more corn will be needed as a result. These two factors will act as strong incentives to increase corn production, and more GM corn use is being seen as a way to do that.

One GM success story is South Africa, which started using GM corn in 1996. It has seen the largest yield increase in corn of all major producers over the last decade, and now has the third highest corn yields in the world behind Mexico and Turkey. Although the adoption of GM seeds is still cost prohibitive in many African countries, rising real GDP growth should help make farming using GM seeds  more accessible.

So what are the key implications? For one, despite the forecast production gains, I am still constructive of global corn prices, largely because I feel demand will outstrip supply over the medium term. More locally, I believe GM usage could bring much increased political and social stability to countries that utilise the technology, particularly in Africa. This is because the increased yields (and resulting overall production) will likely help control food price inflation, which is an important part of general inflation in emerging markets. Corn may still become slightly more expensive in the future, but the increased supply should help keep price increases reasonable on a consumer level, and allow countries to maintain tolerable food price inflation levels. This should ultimately outweigh potential ethical concerns regarding GM implementation.

The A380 passenger version has not performed as well as predicted, with Air Cargo News reporting that Richard Aboulafia, the vice-president of analysis at aerospace research firm Teal Group, stated that the ‘A380 is best regarded as a US$25bn write-off and an act of industrial irresponsibility’.

My colleagues at the freight transportation team note that although bigger is not considered better in the current air freight environment, when the market improves the emphasis will once again be on economies of scale, which is the reason the A380 was touted in the first place. BMI therefore believes that a complete write-off of the A380F is unlikely, with Airbus previously stating that the freighter is ‘still technically part of its product portfolio and can be produced later’.

Regional Breakdown Air Freight Traffic Growth (y-o-y)

Although a recovery in the air freight sector has indeed begun, with IATA reporting that global air freight increased year-on-year (y-o-y) by 28% in March 2010, air cargo operators are still jittery about the strength of the recovery. The most recent example of this is Air France-KLM freezing its cargo capacity, despite the uptick in the market. The cargo unit accounted for about a third of the airline’s US$1.6bn loss in 2009, with the subsidiary in the red to the tune of US$545mn. If a major air freight operator is pulling down the shutters and refusing to increase capacity despite an upturn in the market, this could indicate stormy weather ahead for the air freight sector. The move suggests that the airline believes it already has enough capacity in circulation to meet demand, and so at best is expecting a plateau in air freight volumes or at worst another dip.

In these market conditions, BMI’s freight transportation team believes that Airbus’ decision to hold off the development of the A380F is prudent. The decision does, however, leave the company once again trailing its American rival Boeing. As yet, Airbus has nothing to compare to Boeing’s 747-8 freighter, which is undergoing test flights and is due for delivery to clients in Q4 2010. In fact, Airbus has fallen so far behind Boeing that the company’s A330-200 freighter, a rival to Boeing’s 777F, is only due for delivery in August 2010, while Boeing’s 777F has been in service for over a year longer, beginning operations in February 2009.

Editor’s note: Risk Watchdog will not be updated on Monday 31 May, due to a public holiday in the UK. I wish you all a very entertaining Eurovision Song Contest!

What Exactly Constitutes A Mobile Banking Service?

In truth the term covers a multitude of different services, including ‘apps’ that make it more practical and safer for mobile users in developed markets to access their bank accounts using mobile internet on their handsets. Services like this, however, do little to open up new markets or revenue streams to either banks or mobile operators. Mobile banking and payment services in emerging markets are targeted much more at people who have little or no access to traditional banking services.

Typically it works like this: A mobile customer can set up an account, directly through their mobile phone. They can then make a deposit of money into that account, by making a payment through an agent for the mobile banking service, who would typically be the same person they buy their mobile credit top-ups from. This money will then be credited to the account, and the customer can either use it themselves to buy goods and services from businesses and individuals who also use the mobile payment service, or they can send it to another person. This can be very useful in countries where many people travel to cities to find work, and send money home to families living in rural areas, which they would previously have had to deliver by hand. There is usually no cost for a deposit, but an incremental charge is levied for transfers, and possibly also to withdraw funds.

Africa And Asia Leading Mobile Banking Services

Services like this are taking off in many places, with Asian and African markets leading the way. East Africa is a particular hotspot, and nowhere has mobile banking seen such remarkable success as it has in Kenya. Its mobile market leader Safaricom got the ball rolling, and it can now boast nearly 10mn registered users of its M-PESA mobile money service, which is around 60% of Safaricom’s total subscriber base, over 40% of Kenya’s total mobile subscriber base, and a little under 25% of the Kenyan population. Safaricom officials have said that in 2009, around 11% of Kenya’s GDP passed through the M-PESA system. M-PESA is so ubiquitous now that even people outside its core market, the wealthier users of traditional banking services, are also signing up as their cleaning ladies and gardeners prefer to be paid in M-PESA than in cash.

And the service is evolving. Safaricom has announced a new partnership with Equity Bank which will allow M-PESA users to apply for loans, with their creditworthiness being assessed on their M-PESA record, and the loans money credited to their M-PESA account. Customers can also open interest-earning savings accounts, and make both deposits and withdrawals through the system. Mobile banking is now bringing more sophisticated financial services to the previously unbanked, and the potential is massive. Not only is there clearly still growth in Kenya, but if other markets start to take these services on to the same extent as Kenya, operators could have a very tidy new revenue stream on their hands. In the year ended March 31 2010, Safaricom made KES7.6bn (US$95mn) from M-PESA, or around 9% of its total revenues.

What Are The Risks?

The potential is amazing, but what about the risks? Foremost of all is security. Part of the appeal of these systems is avoiding the security risk of having to carry large amounts of cash. However, criminals are determined, and fraudsters will catch on. If people do not feel that their money is secure, growth could slow. Regulation will be one way of dealing with security risks, but another of the strengths that has allowed services to grow is the comparative ease of establishing one of these accounts. If too much paper work is required, again growth could suffer. Still, these services are opening up a market that didn’t really exist before, and they are still gathering momentum.

What If We’re All Wrong?

While I still believe that a new Korean War is unlikely, I am becoming increasingly concerned about the possibility of a limited armed conflict caused by miscalculation – an idea I adumbrated in Business Monitor Online on June 3 2009. Call this a half-way house between war and peace.

Here’s the crux of my concern. South Korea is adopting a series of punitive measures against the North to punish Pyongyang for sinking its warship Cheonan on March 26 – which is to be expected, of course, given the gravity of the situation. Among these is a more aggressive military posture, such as anti-submarine drills with the US, a more active role in intercepting North Korean ships suspected of carrying nuclear and missile material, and forbidding Northern ships from transiting through the Jeju channel off the South’s south coast. Seoul is also restarting propaganda broadcasts to the North at their joint border, and Pyongyang is threatening to attack the loudspeakers that are used for these purposes.

May The Best Korea Win

Essentially, these measures will increase the chances of Northern and Southern ships clashing again. Now imagine a situation where the two navies start shooting each other in the West Sea. In order to ensure victory, the North then starts using its land-based coastal defences. The South then counter-attacks these artillery and missile placements, thus escalating the conflict from a sea battle to a ground conflict. Pyongyang then retaliates using its extensive artillery against parts of South Korea (or even parts of Seoul). Both sides then move to war footing, and neither can be sure how far the other is willing to go. By this stage, I’d expect both the US and China to be furiously talking to South Korea and North Korea respectively to contain the crisis, but what if the military chain of command breaks down, especially in the North? What if Northern commanders refuse orders to stand down? This would be a possibility if Kim Jong Il becomes incapacitated. Things could easily spin out of control.

The overall result could be a limited war in which hundreds are killed without fundamentally changing the status quo, other than to preclude any rapid improvement in inter-Korean relations. Even without a full-scale war, the ‘limited war’ scenario would be enough to rattle investors and significantly increase South Korea’s risk profile. Meanwhile, don’t be too surprised if Pyongyang carries out another nuclear test this year to demonstrate its displeasure.

The official reason for trying to control trading in the black market rate was to stem inflationary pressures after April’s price spike, which saw official consumer prices in Caracas rising to 36.6% on a 3mma annualised measure (from 28.2% in March). However, I find it hard to believe that the government genuinely believes ‘speculators’ were responsible for the parallel rate’s downward spiral since the beginning of the year, as it was the private brokerages trading in dollar-denominated securities which had provided a relatively efficient method of avoiding currency controls, in turn meeting the huge domestic demand for foreign currency.

With several weeks until the new exchange regime comes into play, importers barred from accessing dollars through official channels will now be forced to use illegal means to continue trading (possibly resorting to offshore exchanges in Panama, Colombia of the Netherlands Antilles), or perhaps even be forced cease trading altogether. This will translate into a further shortage of consumer goods, a factor which will be significantly compounded by government-imposed price caps (in one example of the ludicrous price regulations, Chávez’s government arrested around 40 butchers in early May who had sold meat above regulated prices). Even once the technicalities of the new exchange rate regime are ironed out and implemented, this will do nothing to address the underlying structural issues afflicting Venezuela’s economy. On the contrary, it is highly likely to make the situation much worse.

Addressing Symptoms Not Causes

At the heart of the problem with Venezuela’s currency (and economy in general) is the collapse in domestic productive capacity under Chávez’s regime, where a policy of asset appropriation has placed ineffective bureaucrats in control of the few remaining sources of forex earnings. The result has been to increase the economy’s dependence on oil exports, which reached 95% of total exports as of December last year, compared to just 77% at the start of 2003. At the same time the authorities have pursued a policy of monetary expansion to keep pace with the government’s fiscal profligacy, making it increasingly expensive (and complicated) to maintain the bolivar’s official peg against the dollar. The devaluation and introduction of two official rates (at VEF2.5000/US$ for essential goods and VEF4.3000/US$ for non-essentials) at the start of the year was insufficient to remove these pressures, as the ratio of M2 money supply to US$ reserves implied the market rate was closer to VEF6.0000/US$.

Yet not only is the money supply no longer backed by foreign currency reserves, but even the country’s massive oil exports are insufficient to bolster confidence in the national currency. The accompanying chart shows annual oil exports as a proportion of M2 money supply. With the bolivar value of exports almost halving between 2008 and 2009, M2 supply was over double the value of oil exports in 2009, an indication of how rapidly the printing of money had exceeded the value of the country’s most valuable asset. Clearly, this picture could be reversed by another spike in global oil prices, or the ability of state-owned oil company PDVSA to ramp up production levels, but with the former looking unlikely given the weak outlook for global demand and the latter almost impossible without greater private-sector participation, I’m not hopeful.

The Next Zimbabwe?

On many levels there are clear parallels with Venezuela today and the early stages of Zimbabwe’s hyperinflationary cycle and resultant social and political upheaval; ranging from government appropriation of private (productive assets), an armed militia which depends on political patronage for power, and a massive supply and demand mismatch of foreign exchange. However, Venezuela is not yet at the stage of exponential inflationary rates and civil war. Despite Chávez’s attempts to crackdown on all forms of open dialogue - most recently highlighted by the forced closure of all internet sites that reported the parallel currency rate - there is still a chance that September’s legislative elections will see an opposition victory, which could dampen the government’s ability to continue with its distortive economic policies.

Unfortunately, I remain far from convinced that electoral race will be free and fair, hence cannot rule out significant political turmoil in the run up to September’s ballot. What is clear, in my view, is that Venezuela is set to experience a second consecutive contraction in real GDP growth this year, and that this recent move to control the parallel rate will simply make the necessary economic readjustment that much more painful when it does come.

The monumental quality of both complexes belies a deep uncertainty among European refiners. At the Global Refining Summit in Rotterdam on May 18-20, the mood was grim, with PKN Orlen’s Dariusz Krawiec promising like Winston Churchill that he could offer the industry nothing but ‘blood, sweat and tears’. At the heart of the problem is the structure of European demand and the inability of European refineries to meet it.

A Time Of Troubles

Put simply, Europe consumes too much diesel and not enough of anything else. Historically, higher demand for gasoline and the use of heavy fuel oil in power generation meant that refiners could make significant profits. As oil power stations were phased out and gasoline was gradually replaced with diesel these profits dried up. Europe gradually became a major exporter of gasoline to the US, where diesel demand is much lower, and it started importing diesel, now mainly from the former Soviet Union. As if this was not enough, overall products demand first stalled and then started falling, leaving the European refiners fighting over a smaller and smaller market.

For some, the global economic crisis was the last straw. The more ruthless operators closed underperforming refineries as soon as it became clear that they would not find buyers. Petroplus, Europe’s largest independent refiner, mothballed its Teesside refinery in north-east England in late 2009, following particularly heavy losses. French major Total followed suit in 2010 as it finally managed to close down its Dunkirk refinery in the face of strenuous resistance from the local unions and the government, playing to the crowd as elections loomed. One conference delegate commented that ‘there will be no more closures in France’, a sentiment unlikely to appeal to Petroplus, which has expressed interest in closing its uncompetitive Reichstett refinery near Strasbourg.

The Problem With Being Green

Government involvement of a different kind has put European refiners under even more pressure. Although climate change legislation is likely to prove unavoidable worldwide, the EU has opted to stay ahead of the curve. What may be a boon to environmentalists, however, is a disaster for refiners, particularly those whose outdated plants are least equipped to deal with the changes. According to an estimate made during the conference, at a carbon price of US$30/tonne, the most polluting European refiners would find themselves an additional US$1/bbl worse off than their most efficient peers. With such refineries having already come under severe pressure during the global economic downturn, increasingly stringent regulation is likely to push the weakest off the edge. This of course will be of benefit to the strongest, which will be faced with less competition. Speaking to BMI in Rotterdam, a representative of Italy’s Saras agreed that the loss of weaker peers would be of benefit to his company’s position in the region. In reality, however, the main beneficiaries are most likely to come from outside Europe.

When Reliance Industries’ Antony Francis was introduced as the man who could destroy any European refiner overnight, like any good joke it contained more than just a grain of truth. Francis himself, sitting unobtrusively towards the back of the hall, had done nothing to court attention, but all heads turned to him as soon has his name was mentioned. Reliance’s Jamnagar refinery was indeed looming in the thoughts of many of those present. With 1.2mn b/d capacity, it is three times the size of Pernis, and is only slightly short of equalling the entire capacity of the Netherlands. Its scale, although well known, did not seem to have sunk in with all of the delegates. When one delegate asked how many ships carrying refined products left the refinery every day, Francis’ answer was disarmingly honest. ‘I don’t know’, he answered, ‘there are so many.’

Sun Setting In The West

This indeed seems to be the way that the wind is blowing. With a declining market, increasing regulations and investment requirements, and a string of huge extra-regional rivals breathing down their necks, there is very little to recommend European refining at the moment. In such an environment, few are assured of survival. Some, such as PKN Orlen and the Czech Republic’s ?eská Rafinérská, see their competition as coming from further inland, from Belarus and Ukraine. Others further to the west will find their position squeezed by refiners from the Middle East, India, and even potentially from Africa in the long term. Finding a strategy to deal with this is much harder than making the diagnosis. Some, such as Saras, place huge faith in their own high technological competency and flexibility. Petroplus has taken a different tack and is seeking to expand aggressively to strengthen its overall position in the market. The majors, though, with the exception of the conservative ExxonMobil, have long since conceded that the writing is on the wall.

This was perhaps the theme that ran most clearly throughout the conference: that the industry has reached a point where not all players will be able to continue. At the very start of the conference, Krawiec stated that PKN Orlen’s underlying market assumption was that there is around 7mn b/d of excess capacity in the industry worldwide, compared with a 3mn b/d surplus during the industry’s golden age from 2004-2007. Placed in context, this means that around 5% of world capacity will need to be cut in the near future. As the presence of a sizeable delegation from Saudi Aramco attested however, emerging markets are not going to sit still and wait for European refiners to arrange a peaceful decline for themselves. While Pernis and Europoort should be better placed than most to survive the coming storm, the bad times for European refiners are about to get much worse.

•    Charting A Path Of Its Own: Sunday’s agreement is the most significant result so far of Lula’s efforts to catapult Brazil onto the centre stage of global diplomacy, and has allowed the country to assert its ability to engineer tangible results where the attempts of more traditional diplomatic powers have floundered.

•    Leading The South’s Rise: The agreement is further indication that Brazil is looking to place itself at the forefront of the ‘Global South’ as developing economies seek to translate their undoubted economic significance into political influence. Whereas Brazil’s previous diplomatic efforts have been focused within Latin America, this deal shows the country is ready to step up as a global political force prepared to play a prominent role in political issues far from its own shores.

•    Pushing UN Credentials: In the longer term, Brazil’s involvement in such questions of global significance is likely to bolster its case for recognition in key global institutions. Brazil is currently one of the non-permanent members of the UN Security Council, and a capacity to translate this added diplomatic prominence into tangible results is likely to bode well for future attempts to be elected to other international decision-making bodies.

ISNA

Playing For High Stakes
While the symbolism is overwhelmingly positive, the substance of the deal warrants a little more caution, as our Iran analyst points out today on Business Monitor Online. The deal could delay – at least temporarily – the prospect of further sanctions on Iran, undermining one of the Obama administration’s top international priorities. However, given that the agreement doesn’t meet the West’s key requirement – namely an end to Iran’s enrichment of uranium – the US is likely to continue to push hard for a new round of sanctions, seemingly putting Lula at odds with Washington.

More worrying for Brazil is the potential for Iran to renege on elements of the swap deal. If Iran is subsequently found to have been developing secret nuclear weapons, it could leave Brazil in the uncomfortable position of being perceived to have aligned itself with a country in contravention of international agreements. This would have an even more detrimental effect on Brazil’s relations with the US, in turn potentially damaging its wider international positioning as a leading diplomatic force.

Increased Likelihood Of Decentralised Demonstrations
Over the past week, clashes between the army and the ‘Red Shirts’ have led to 35 casualties and over 200 injured, marking Thailand’s worst political violence in two decades. Despite the tightening noose around the main protest area, there is an increasing probability of smaller-scale demonstrations erupting in various parts of the country, particularly in the rural areas if the violence persists. Around 500 members of the United Front for Democracy against Dictatorship (UDD, the political arm of the ‘Red Shirts’) converged at the Chang Mai railway station on May 16 to pressure the government to refrain from using force against the protestors in Ratchaprasong. If this movement is duplicated in other provinces, the scope of unrest will no longer be contained in Bangkok.

Is Civil War A Possibility?
For now, the chance of an outright civil war in Thailand is low but growing. Firstly, the much revered (but aging) Thai monarch, King Bhumibol Adulyadej, has been ill for an extended period and has conspicuously avoided mentioning about the ongoing unrest. In his absence, Thailand has and will continue to lack a common unifying ground, potentially leading to even more conflict. Secondly, while the military appears united in the crackdown against the ‘Red Shirts’ at this point, there were signs just a few months ago that the military is split on the use of more violence. It is conceivable that the pro-Thaksin elements within the military will split from the main unit, triggering civil war.

Spread of Indonesia over Thailand 5-Year CDS (bottom)

Underperformance Of Thai Sovereign Debt To Continue
In contrast to Thailand, Indonesia has enjoyed greater political stability and economic growth over the last few years. As such, the spread of Indonesia’s 5-Year CDS over Thailand’s 5-Year CDS has narrowed considerably from around 150bps in the pre-crisis period to 30bps at the time of writing, the spike in spread in Q408 notwithstanding. This should begin to narrow and there is a distinct possibility that Indonesia’s 5-year CDS spread may trade inside of Thailand’s in the near future, with the key risk between a prolonged return of risk aversion leading to a knee-jerk selloff in Indonesian assets.

Global Private Equity Financing (US$bn)

In my view, should the regulation be passed in its current format, the impact stands to be predominantly threefold. First, Europe will see international funds slashing their funding allocation to European-based PE funds. Second, this may serve to push European funds away from eurozone soil altogether and into offshore locations exempt from such rules. And finally, the first two factors combined will likely serve to hit the volume of PE deal making hard. This all serves to pose a threat to BMI’s core view that the private sector will continue to take up the slack from the public sector in corporate financing, as stimuli is reigned in. While the impending heightening of regulation does not necessarily change this view, Risk Watchdog, however, sees PE’s role within this as becoming increasingly muted.

The component of the Alternative Investment (AI) regulation which has been the subject of the most controversy has been the so-called PE passport. This requires funds from ‘third countries’ (those based outside the Union) to comply with European regulation if they wish to market themselves in the 27-nation trading bloc. One part of this legislation is that EU-based funds will be forced to use locally-based banks as depositories. While in principle the passport is an attempt to facilitate EU-wide marketing by fund-managers, in practice, such regulation is no less than protectionist, as it discriminates against firms attempting to access the EU market. Essentially it gives the EU ability to pick and choose which funds it will allow to enter Europe.

So, who stands to be the biggest loser in all of this? You guessed it: the UK, which is home to around 60% of Europe’s PE funds and which has been the regional stalwart in the industry’s recovery in the year-to-date. PE M&A is up an astonishing 516% y-o-y so far in 2010, totalling US$6.3bn of deals, according to Thomson Reuters data. Indeed the new British coalition government is hoping that the application of EU regulation will be left to the discretion of individual countries – in this respect, the classic EU principle of ‘subsidiarity’, whereby the Union does not take action unless it is more effective than action taken at the national level, would come in very handy. It seem that the passing of EU-wide legislation is based on an assumption that the eurozone is a unified decisions making bloc, rather than the almost non-existent politician union that is it is often viewed as from this side of the English channel.

The Liberian economy demonstrated resilience amid the global recession, boding well for its future prospects. BMI estimates that real GDP growth came in at a respectable 4.7% in 2009, making Liberia a regional outperformer; average growth in Sub-Saharan Africa stood at an estimated 2.2%. While many nations saw foreign investors withdraw from operations amid plummeting commodity prices and hence reduced returns, the major players in Liberia stayed put, albeit scaling back their investment plans. This bears testament to the attractiveness of the market: not only does it benefit from plentiful natural resources, but the political environment is broadly stable.

(Chart below shows real GDP growth, %. Source: IMF, BMI forecasts)

Certainly, the prospects for the mining sector look strong, with foreign investors continuing to flock in. At present, Brazil’s Vale (the world’s top iron ore producer) is in talks with the Liberian investment commission over a possible concession. If the deal goes ahead, it will be the sixth major iron ore mining deal awarded to a foreign firm in the past five years, adding to US$10bn worth of agreements already made. The leading foreign investors at present include ArcelorMittal, BHP Billiton and China Union.

China’s interests in Liberia are not limited to the mining sector. In April 2010, China’s Deputy Minister of Commerce led a delegation of Chinese officials in a four-day official visit to Liberia, with the objective of promoting bilateral trade and economic cooperation between the two nations. This is in line with a broad trend across Sub-Saharan Africa wherein fast-growing emerging market giants - not just China but also India and Brazil, for example - are building links with African countries in a bid to secure supplies of natural resources. In this regard, Liberia offers diamonds, coffee, cocoa, rubber and timber, in addition to the aforementioned metals.

The natural resources provide the initial draw for investors, but the authorities are also working hard to improve the business environment in order to attract interest from abroad. Indeed, Liberia was among the top ten reformers globally in the World Bank’s 2010 Doing Business survey. At present, Liberia is ranked 149th globally of 183 nations - and 23rd out of 46 Sub-Saharan African nations - by the World Bank in terms of its business environment. It is relatively easy to start a business and trade across borders; registering property and enforcing contracts are more difficult to achieve.

While the ongoing foreign investment is clearly conducive to real GDP growth, Liberia’s economy is also benefiting from sound macroeconomic policy. As the International Monetary Fund (IMF) noted in a press release on April 19, 2010, ‘performance under the Fund supported economic program has been strong… fiscal and monetary objectives through end-December 2009 have been achieved’. Importantly, the nation is approaching completion point under the Heavily Indebted Poor Countries (HIPC) initiative - if this is reached, it will entail a lightening of the debt load which has been weighing on the fiscal coffers. Outstanding public sector external debt equated to a massive 473% of GDP in 2008, according to IMF estimates. Recent developments bode well for Liberia reaching HIPC completion point. In addition to the aforementioned achievement of macroeconomic objectives, the Liberian authorities have cut foreign debt to US$1.7bn in August 2009 through a US$1.2bn buyback of outstanding government arrears.

The coalition government between the Conservatives and Liberal Democrats brings together the largest and third largest blocs within the new House of Commons, and will have a majority of 74. This is a good working majority for new Conservative Prime Minister David Cameron, and is larger than the 64-seat majority under Tony Blair in 2005 or John Major’s 21 in 1992. This is crucial because it will allow room for small-scale rebellions by unhappy MPs from either party, and will allow the Conservatives to secure passage for legislation upon which the Liberal Democrats wish to abstain. Put simply, this was the best and most cohesive deal which could be put together under the prevailing parliamentary arithmetic.

Turning to the joint programme, there is much both sides will like contained within it, with tax, spending, and social priorities all being effectively merged.

There are a couple of areas likely to lead to some friction over the medium term, though.

The first is the Conservative promise to hold a referendum on electoral reform, which is a Liberal Democrat pet project. Conservative activists are notably opposed, and even if Conservative MPs vote in favour of a national vote, the party may still campaign for a ‘No’ vote. This would likely cause tensions with their Lib Dem partners.

The second potential policy fault-line is over the replacement for the Trident nuclear weapons system. The Liberal Democrats wanted to scrap it, but the programme is in line with the Conservative policy to keep it. Given the cost, this could cause problems.

More detailed coverage of the durability of the new government can be found on Business Monitor Online.

Growth Drivers

• With uncertainty across the eurozone rife, Turkey’s position as one of our favourite regional consumer players is good news for MGR. BMI’s Food and Drink Team thinks the industry will comfortably outperform most of emerging Europe in 2010. To 2014, the Food and Drink Team sees annual average headline MGR sales growing at 12.7%.
• I look at the fact that only 30% of grocery sales (house estimate) are currently accounted for by organised retail and the fact that incomes are expected to spike considerably over the coming years. This leads me to the conclusion that tremendous scope for growth exists.
• Carrefour and Tesco are already there and competing with well established domestic players like Migros Turk and B?M Birlesik Magazalar A. Walmart is also rumoured to be interested in investing in Turkey.
• I think the discount segment will play an increasingly important role in the formalisation process. Its low-price no-frills model is well suited to tempting in consumers on the edges of organised retail. This will be particularly important outside Istanbul, where spending power is weaker.

Risks To Outlook

• In terms of risks to outlook, I would say that ongoing double-digit unemployment remains a concern. A lower joblessness rate is probably needed to speed up the transition to organised retail outside Istanbul, particularly when it comes to more expensive hypermarket and supermarket stores.

• On a company level, further weakening of currencies like the EUR and GBP against the TRY could impact the plans of existing multinational retailers as expansion costs become more expensive.

A glimpse at regional price–to–earnings ratios tells an interesting story of investor sentiment towards LatAm equities over the past five years. Back in January 2005, the Dow Jones had a higher trailing P/E ratio than all other major regional markets. Five years on and this picture has been reversed, with the Dow now bottom of the pile in valuation terms. Such a reversal in trend is not particularly surprising, since the 2005–2007 period was characterised by increasing appetite for high yield, high-risk EM stocks, and many South American economies managed to weather the post-crisis recession through exposure to Chinese growth, which translated into rapid gains for equities from Q109 onwards.

Yet even with the recent fall in P/E ratios, most regional bourses still remain at or near pre–crisis highs, and in the case of Colombia, equity valuations continue to post new highs, a trend which is not in line with a much weaker external environment.

Good…But Not That Good

While Latin American equities may be justified in trading above their US counterparts, I seriously doubt whether the macro outlook for these economies is better than it was back in the post–crisis, EM heyday. For one, demand for regional exports from the US consumer – a major determinant of Mexican and Colombian economic growth – is incapable of returning to previous highs without banks lending, something that appears highly unlikely in the current environment. Secondly, the precipitous fall in China’s real estate market brings to the fore a double-dip downturn in Chinese growth (a core scenario of Business Monitor’s Asia team), which I believe is yet to be priced into Brazilian, Chilean and perhaps even Peruvian stock markets.

As outlined above, it is too early to say that these markets have now reached their peaks, and I certainly remain bullish towards both the EM and Latin American growth story over the long term. This is particularly true for those economies which meet BMI’s EM checklist criteria; i.e. sound banking sectors, resource wealth, generally market-friendly policies, strong demographics and low levels of private debt. However, such long-term optimism does not justify current equity valuations, which I believe are not currently pricing in a much weaker external environment in the latter stages of this year and into 2011.

On the stability of the bond markets and eurozone:

“I never comment on the market itself. I think that it is not very well known how solid the euro area actually is - the concept of the euro area. I, myself, over 20 years, had to explain tirelessly, on a lot of occasions, what we have been doing. So, I have no further comments to make.”

On the stability of the European banking sector on the back of the worsening treasury market:

“Strict implementation of the Stability and Growth Pact and of the excessive deficit procedures is crucial. I have no other comment. Of course, it is better to have low treasury interest rates than to have higher treasury interest rates. This is true, and this is the way you are rewarded when you do the job.”

On a low growth and low inflation outlook for the eurozone:

“In terms of sustainable growth and job creation, if you are obviously in a very bad situation, say in terms of fiscal policy, then you have no confidence in your country, and then households have no confidence, entrepreneurs have no confidence, and you cannot expect a recovery that would be satisfactory.”

On inflation targeting:

“…what happens for inflation in 2011 as an average is not, even for the strict inflation targeters, the target”

On fiscal austerity and monetary policy:

“Consolidation of public finances should start in 2011 at the latest and will have to exceed substantially the annual adjustment of 0.5%”

“The Governing Council will, in early March (May, sic) take decisions on the continued implementation of the gradual phasing-out of the extraordinary liquidity measures that are not needed to the same extent as in the past.”

On a question on Germany:

“…I cannot embark on responding to questions on particular countries. We are looking at a continent: 330 million people, 16 countriers. It is as numerous as the United States, and I doubt that, in a press conference, Ben Bernanke would have a question on Alaska or Massachussets.”

If you can’t be bothered to read that much transcripted text, allow me to summarize: 1) In the midst of the worst financial crisis in the eurozone’s history, the governor of the European Central Bank refuses to discuss individual countries or the financial markets. 2) Because of his constraints in not wanting to talk about individual countries or markets, Trichet completely ignored Greece in his introductory statement. 3) In the press conference, he mentioned the Stability and Growth Pact six times and on one of those occasions, it was in response to a question about how to restore stability to the banking sector. Does anyone else find it absolutely terrifying that the Governor of the ECB believes that a failed ex-ante policy is his solution to a very real crisis today? 4) It is clear that there is no policy cohesion between the EU, individual eurozone member governments and the ECB. Many people have been asking how the EU will cope with its first real macroeconomic crisis… the answer now is clearly leaning towards failure.

I will leave dear Risk Watchdog readers with three more quick gems of Trichet quotes. These ones from July 3 2008, when the ECB hiked its refinancing rate by 25bps nine months after the beginning of the global credit crunch.

“As regards domestic developments, the fundamentals of the euro area economy remain sound and the euro area does not suffer from major imbalances.”

“Looking ahead, on the basis of current futures prices for these commodities, the annual HICP inflation rate is likely to remain well above 2% for quite some time, moderating only gradually in 2009.”

“There is… a very strong concern that price and wage-setting behaviour could add to inflationary pressures via broadly based second-round effects.”

Seriously? Do you think anyone in Southern Europe (or even Germany, for that matter) is concerned about a wage-price spiral now? Well, there may be one person:

(NB: All quotes come from transcripts available on the European Central Bank website. Opinions expressed on Risk Watchdog are of the blogger and do not necessarily represent those of Business Monitor International)

(Click on chart for full size)

Germany - 2-year treasury yield, %

• Sophisticated Project Finance operations: Australia comes top in BMI’s global Project Finance Ratings. The country was one of the first to embark on the public private partnership (PPP) scheme using private funding to develop infrastructure projects. This has brought with it a strong precedent, and unlike the US, which is only just coming round to the idea, Australia has had plenty of time to get the regulations right, and has done so - unlike the UK, which still seems to fumble.
• Attractive Business Environment: Australia has the second-most attractive business environment globally, according to BMI’s Infrastructure Business Environment Ratings. Strong potential for infrastructure investment - there is lots of land still to develop - and a stable and business orientated government with sophisticated financial and legal regulations limits investor risk.
• Infrastructure investment potential: Despite being a developed market, the sheer size of Australia means there is still plenty of demand for infrastructure. Around US$100bn is needed for electricity generating and transmission infrastructure over the next decade, and the metropolitan area of Sydney alone has a US$45bn 10-year investment plan for urban transport. Added to this is growing investment in freight transport. From ports to railways, investment is being expedited in order to take advantage of current insatiable demand for raw materials from China.

These three factors mean that Australia has fundamental strengths which I believe are not matched in any other developed market covered by the Infrastructure Team. Other contenders for the top spot are weakened by the limited potential for investment (Japan, France, Germany), problems with the business environment (Greece), and a lack of precedent for successful PPPs (US). The UK is perhaps the biggest challenger for the position, especially with the 2012 Olympics preparations, but a recent spotlight on failing PPPs (for example the Tube Lines debacle) and continued financial instability mean that Australia pulls ahead.

Key Risks

Despite all of the positive indicators for Australia, there are a number of risks to take into consideration:

• Demand for freight infrastructure is extremely closely tied to China. Therefore, a slowdown in China in 2011, which BMI believes will be the case, will hit demand for raw materials, and could stymie investment plans in export terminals and freight railways. Furthermore, the imposition of a new mining tax by the Australian government could hinder production, and therefore the need for increased freight transport capacity.
• Another threat is the government’s position on the Carbon Pollution Reduction Scheme. Uncertainty surrounding the scheme - most recently a decision on the scheme was put on hold until 2012 - is threatening investment into new electricity capacity.
• Finally, a relative slowdown has hit the construction industry over the past month, with the Australian Construction Index, based on activity, orders, new business and employment, contracting in March 2010. It is unclear if this is the beginning of a downward trend, or a mere blip in the growth story.

Only two and a half days till the UK election!

Don’t worry, this is not a party political broadcast. In the interests of preserving Business Monitor International (BMI)’s impartial status, I will not endorse any party ahead of the election. What I will do is offer a brief and perhaps somewhat cynical guide to Thursday’s landmark vote. I should mention that this is merely the view of one jaded analyst, and does not necessarily reflect BMI’s position as a whole. You are free to interpret it as you wish:

• Opinion polls don’t matter that much. As clichéd as it is, I agree with politicians who say that the only poll that matters is on voting day. Several recent polls have put all three main parties within the margin of error, and with so many new voters registering, and many still undecided, anything can happen.
• Manifestos don’t matter. I have long believed that you should vote for whichever party’s manifesto you most disagree with, on the basis that politicians do the opposite of their stated goals once in power. At best, manifestos are only a very rough guide to a party’s policies. Also, bear in mind that ‘reality’ can force unexpected policies. A good example was the US in 2008, when a conservative, pro-business US president nationalised key American financial institutions. In the case of the UK, the Labour Party’s nationalisation of banks in late 2008 was merely fulfilling one of the promises of its 1983 election manifesto, which was described as the ‘longest suicide note in history’.
• Whoever wins will have a weak mandate at best. According to my interpretation of latest opinion polls (ignore for a moment my first bullet-point downplaying polls), 67% of voters do not support a Conservative government (though even greater numbers do not support a Labour or Liberal Democrat government). Some commentators in Britain criticised the US election in 2000 in which the candidate with fewer votes formed the new administration, but this could easily happen here.
• That the Conservatives and Liberal Democrats aren’t doing better in opinion polls (again, disregard point 1) after everything the UK has been through in recent years is a damning indictment of the state of confidence the electorate has in the political class.
• A coalition government would hardly be the end of the world – although I admit that there is great uncertainty as to how it would work in the UK’s Westminster system of government. In many countries, coalition rule is the norm, and given the low poll numbers in circulation, it is something that we in the UK may have to get used to.
• Regardless of which party wins, it will probably take much more than one parliamentary term (typically five years) to sort out the UK’s problems. I am not merely speaking of the economy, budget deficit, and national debt. I am also talking about issues such as crime and policing, which have not featured as much as you’d expect in the campaign.
• Don’t expect too much say in how the country is run, post-election. By this I mean that once the government is elected, and especially in the event of a coalition, much of the decision-making will take place behind closed doors.

• Fasten your seatbelt for a bumpy ride.

Unlike the now well-established receiving (regasification) floating LNG vessels, liquefaction ships have yet-to-be commercially tested. At present several shipyards and oil companies are competing to bring the first one on-stream by the middle of the decade, with the charge led by Royal Dutch Shell and its South Korean contractor Samsung. The test ground for FLNGs looks set to be Australia’s northern coast, but the principal virtue of the technology is its logistical flexibility.

What are other benefits of FLNG versus the standard onshore liquefaction projects?

• No need for costly, environmentally damaging and high-maintenance processing facilities.
• Ability to access smaller, remote fields that would otherwise be commercially unfeasible.
• No strings to land mean less contact with governments. In developed countries this means less red tape; in emerging countries it means fewer back-door dealings. Out of sight is out of mind.
• Much smaller chance of disruption due to terrorist attacks, activist protests or labour disputes.

This opens up opportunities for more gas production in practically every region. In South East Asia, smaller deposits could be tapped to supply a network of mid-scale receiving terminals among the archipelagos. West Africa’s large offshore gas potential could be harnessed without the need to price in the risk of terrorist attacks and corrupt local officials. North American waters could be developed with a much smaller environmental footprint.

More specifically who will benefit?

• South Korea’s high-tech ship yards.
• LNG traders such as Golar and Shell.
• Specialised gas producers like Woodside and BG.

Who will lose out?

• In the medium term, the governments of poor but gas-rich coastal states.

FLNG ships eliminate the need for onshore developments, meaning host states will not benefit from the massive inflows of FDI that accompany onshore terminals. Jobs will not be created, roads not built, and kickbacks reduced. It is important to keep in mind just how crucial an LNG plant can be for a small country. The PNG LNG terminal being built by ExxonMobil in Papua New Guinea, for example, is set to double the country’s GDP. No wonder East Timor is up in arms over Woodside’s decision to scrap a terminal in Timor and develop the Sunrise fields through FLNG.

Longer term, however, FLNGs will commercialise plenty of fields that would otherwise be untouched, meaning more gross royalties for the treasuries. Ultimately, FLNG is a win-win technology for the producers, host governments (ie states that own the deposits), and consumers benefiting from greater supply.

But there’s more to it than that. Assad is pictured wearing all sorts of expressions. Sometimes he’s serious, other times he’s jovial. He’s also wistful, pensive, concerned, happy and sombre. In other words, he is shown displaying the full range of human emotions, and this, I think, is key, for most Syrians are unlikely to ever see Assad up close, let alone meet him. In the same way that people in the West often fall into the trap of believing they ‘know’ famous people even though they’ve only read about them or seen them on TV, I wouldn’t be surprised if many (most?) Syrians truly believed that they ‘knew’ Assad. And it is this collective empathy for him that helps to sustain the political system.

Of course, I can’t really know if this theory is true, because it’s impossible to talk about Syrian politics with Syrians, at least not before you get to know someone very well indeed. Maybe this will change. After all, Syria is slowly opening up and coming out of the diplomatic wilderness. The government is keen to encourage foreign investment, and is increasingly looking west. And foreigners are paying attention – BMI’s clients have lately been showing increasing interest in our Syrian country risk coverage. So this begs the question: over time, will increased economic integration with the outside world (and particularly with the West) result in greater political liberalisation at home?

At the moment, the regime does not allow much in the way of political freedom. The media is heavily controlled, often via self-censorship, the government blocks internet sites such as facebook.com and amazon.com (although the internet cafes frequented by foreigners seem to easily get round the blocks, so they can’t be particularly strong), and even though my untrained eye could not spot the secret police, from what I heard from foreigners who had spent longer in the country than I, they aren’t that difficult to recognise once you know what you’re looking for. That said, almost every roof has a satellite dish. And if the guys who run the internet cafes can get past the blocks, then surely Syrians with internet at home and who have modest tech skills should be able to get round the blocks too? So will the greater access to ideas from the outside world via TV and the internet instil in the populace the burning desire for a representative political system?

I have my doubts to be honest. Indeed, despite the abundance of satellite dishes, I am sceptical about how open to external ideas, let alone Western political ideals, most Syrians really are. I base this on my admittedly narrow observation that Syrians don’t seem to read much. I travelled on multiple public minibuses and coaches during my visit, and went all across the country. I only saw one person reading a newspaper, and nobody I saw had a book. This is in sharp contrast to my experience travelling around the UK (and Europe), where books are commonplace. And conversation did not replace reading either – almost everyone travelled in silence. To me, this lack of reading hints at a lack of interest in the outside world, or of gaining knowledge for knowledge’s sake. (Yes, many people in the UK read books that are hardly likely to impart much in the way of knowledge; but many likewise read books that challenge them). I ask the following question: how can political change occur within a society that does not seem to value new ideas and knowledge?

The lack of interest in reading is certainly not limited to Syria, but it is particularly evident in the Arab world. Indeed, the UN estimated in 2002 that more books were translated into Spanish every year than had ever been translated into Arabic. That speaks volumes.

When Fujifilm announced a ‘full-scale entry’ into the pharmaceutical sector earlier this year, many market observers were left head scratching. Surely companies should focus on their core competencies? What does Fujifilm know about developing and selling medicines? Who is going to buy these drugs?

I, on the other hand, saw the beginning of a trend that has played out nicely. Beleaguered companies (as Fujifilm very much is ) see medical services as a sustainable and expanding business, principally because people will always get sick and the global population is both growing and ageing. Unlike other industries, the pharmaceuticals sector is also resilient to economic downturns, as it has recently demonstrated. Consider the following:

• Demand for Fujifilm’s core competency has evaporated. The advent of digital cameras means that photographic film accounts for just 2% of the company’s revenue (down from 19% in 2001). To grow profits and sales, Fujifilm has to evolve and develop new products.
• Fujifilm will have help in its new venture. The company is partnering with Mitsubishi Corporation and Toho Holdings, which have expertise in sourcing raw ingredients and pharmaceutical distribution, respectively.
• There is unmet local demand. Japan’s generic drug sector is an ‘emerging market’ in its own right. Sales of these affordable pharmaceuticals are forecast to increase from US$7.3bn in 2009 to US$10.3bn in 2014 – a rise of nearly 50%. Doctors and patients in Japan are also more likely to prescribe and consume locally-made generic medicines rather than imported brands.

Since Fujifilm’s move into healthcare, several other firms have followed suit, fulfilling what I have termed the ‘bioelectric paradigm shift’.

• In March, technology conglomerate Hitachi formed a partnership with US-based NextDocs. The firms plan to assist Japanese life science companies with the submission of regulatory dossiers.
• In April, Japan-based Panasonic announced expansion plans for its Singapore research and development centre, which traditionally focused on the audiovisual, automotive, computer and communications industries. The facility will now work on new electronic applications in the environmental, energy and medical sectors.
• That same month, Fujitsu unveiled a sensor that can diagnose diseases in 5-10 minutes – 100 times faster than existing solutions. The device was developed in partnership with the Technical University of Munich and targets proteins unique to various diseases.

Technology companies are not alone in moving into the healthcare sector. Phone companies are increasingly promoting the benefits of telemedicine, while food and drink firms have high hopes for nutraceuticals.

]]> http://www.riskwatchdog.com/2010/04/28/fujifilm-triggers-a-bioelectric-paradigm-shift/feed/ http://www.riskwatchdog.com/2010/04/27/north-korea-growing-possibility-of-a-third-nuclear-test/ http://www.riskwatchdog.com/2010/04/27/north-korea-growing-possibility-of-a-third-nuclear-test/#comments Tue, 27 Apr 2010 14:05:27 +0000 http://www.riskwatchdog.com/?p=1261 Read more...]]]> One thing which I believe is becoming increasingly likely is a third nuclear test by North Korea. Last May, when North Korea tested its second nuke, I suggested that the entire nuclear dispute had taken on the feeling of one too many a season of ‘24’ – i.e. it had lost the ability to shock us. I still feel that this is the case. As for the reasons for a third test, I see three factors:

• Technical reasons: North Korea needs to fine-tune its nuclear weapons.
• International reasons: North Korea wants to be formally recognised as a nuclear power. The more bombs it tests, the more it cannot be ignored as such.
• Internal political reasons: North Korean leader Kim Jong Il is reportedly ill and preparing his third son, Kim Jong Un, to succeed him. In this respect, Kim will need the support of the powerful military. Testing a nuke would play well with hardline generals. Also, creating a martial atmosphere at home would distract public attention away from the dire economic situation caused by last November’s bungled currency reform.

Despite the above, I believe there are some possible constraints on Pyongyang testing a third time:

• Chinese opposition: Beijing doesn’t want Kim to be too noisy. They would prefer if he kept his head down. However, Chinese influence over North Korea is limited, in my view, since Beijing will not cut off aid and investment lest it causes its neighbour to collapse.
• Nuclear fatigue: The more North Korea tests a nuke, the more mundane this becomes, and the less the shock value.
• Lesser options: Pyongyang has lesser options, such as testing a long-range missile, which would certainly grab international attention.

Overall though, I feel that the balance of factors is tilting towards a new nuclear test over the coming few months or year. To be quite honest, I think North Korea’s enemies should be in favour of more nuke tests, since Pyongyang would deplete its small nuclear arsenal (believed to number fewer than 10).

Keep An Eye On The Koreas

Also worth watching are the consequences of the sinking of a South Korean warship with the loss of 46 lives on March 26, which Seoul has all but officially blamed on a North Korean torpedo. Southern president Lee Myung-bak has been criticised for his handling of the incident, amid suspicions of a cover-up. If the current investigation formally accuses Pyongyang, Seoul has few options for retaliating, since any punitive military action could trigger a war – or quasi-war. Therefore, it will have to grit its teeth and perhaps push for more economic forms of punishment – if at all possible. But given that sanctions are already extremely tight due to North Korea’s past shenanigans, it remains unclear if much more can be done.

The good news is that assuming no abnormal developments on the Korean Peninsula, there are unlikely to be any economic repercussions for the South, which is enjoying an impressive recovery (in fact, BMI’s Asia Team has just raised its 2010 real GDP growth forecast to 5.5% from 4.6% previously). Furthermore, most investors are accustomed to Northern sabre-rattling, and if a nuke test does take place, the impact on the Kospi stock market and won currency is likely to be limited.

Germany - Exports By Destination, % of Total

With Germany being the world’s single largest trading economy, their export dynamics are a useful indicator for wider global structural shifts. To be sure, the chart above reflects the steadily increasing size of emerging markets relative to global GDP over the past decade, while also highlighting the increased domestic demand being generated by key German EM trading partners such as Russia, Poland, Turkey and China.

Going forward, considering the growth outlooks for EM and developed states over the coming decade, there is every reason to expect the trend seen from 1999-2008 to continue going forward. Business Monitor forecasts Emerging Europe growth to average over 4.5% in the next 10 years, while eurozone growth is expected to lag at around 1.5%. By 2019, four of the top six largest economies in the world will be emerging markets compared to just one right now. As a result, for German exporters, tapping the EM growth story will continue to be crucial for their strategic outlooks.

First on the list is the divestment of stakes in state-owned infrastructure assets. Parts of state owned railway group, OSE are expected to be on the list, as well as non-controlling stakes in utilities such as: EYDAP, owner and operator of water and wastewater systems in Athens; EYATH, owner and operator of water and wastewater systems in Thessaloniki; and, DEPA, the owner and operator or natural gas infrastructure in Greece. In total, the government is hoping to raise close to EUR1.5bn from this venture.

Staunch opposition from workers’ unions, backed by groups like PAME – the nucleus of the communist party KKE – is the greatest challenge the government will face in trying to divest stakes in state-owned infrastructure. However, timing is everything and BMI’s Infrastructure Team believes that Greece’s government now has a crucial window of opportunity to press ahead with the privatisation (or unbundling) of part-owned or state-owned assets, as the urgency to ‘trim the fat’ of the public balance sheet gives the government a strong mandate to do so.

Secondly, the dire condition of Greek public finances has prompted the government to seek investments that can jump-start growth and therefore there is upside potential for the PPP and concession sector. The newly established Infrastructure Ministry is preparing to launch tenders for airports, motorways, metros and trams within the year. The EUR1bn concession for the construction, operation and maintenance of the airport of Casteli in Crete is going to be the flagship PPP venture and a litmus test of the attractiveness of the market and BMI’s view.

Cocoa Prices

However, upside risks remain. Firstly, from a technical perspective, I highlight that any break and close (on a weekly basis) above short-term resistance around the GBP2,240/tonne area would negate this bearish view, as was seen in Q408 and Q309. Secondly, although I expect the cocoa market to slacken in coming quarters, it remains tight on a historical basis and recent supply and demand dynamics are supportive of additional price gains. On the supply front, cumulative cocoa arrivals at ports in top exporter Cote, d’Ivoire have begun to lag last year’s levels and recent trucker strikes in Cote, d’Ivoire had the effect of delaying the arrival of cocoa to ports. Furthermore, the outlook for Ghanaian cocoa production and exports has weakened in recent months and I expect the global cocoa market to register a small deficit in 2009/10.

Inventories & Prices

On the demand side, recent cocoa grinding data showed a sharp rise in cocoa demand. Q109 data showed that grindings in Europe rose by 8.1% year-on-year in Q110 while North American grindings rose by a stellar 17.2% y-o-y over the same period. A combination of fewer cocoa beans reaching the market and a rise in demand for cocoa provides a more supportive fundamental picture, which could help overturn my short-term bearish outlook in coming weeks.

According to my colleagues at BMI, the answer is an unequivocal no. So what’s holding Mexico back? Well, a number of points spring to mind, ranging from a weak domestic consumer (private consumption contracted 6.1% in real terms last year, compared to 4.1% growth in Brazil) to the increasingly brazen show of power from local drug cartels. From my perspective, though, a more indicative aspect of Mexico’s structural failings is its external accounts, long the Achilles’ heel of the country’s broader macro outlook.

Since 1996 Mexico has run a persistent trade deficit, and while the start of 2010 has witnessed a rapid rebound in export-led domestic economic activity, the trade balance is unlikely to head back to sustained surplus anytime soon. Lack of near-term potential for significant energy reform and overdependence on manufactured exports to the US will continue to act as longer-term drag on the country’s export prospects, resulting in the ongoing need to attract overseas capital to fund the trade gap.

Remittances, FDI inflows and portfolio investment have traditionally filled this gap, but there is no guarantee it can continue indefinitely. A pretty bleak outlook for the US labour market means money received from the Mexican diaspora looks set to remain well below pre-crisis levels for the foreseeable future. As for FDI and portfolio investment, the outlook here is also uncertain. Short term there’s plenty of potential for Mexican markets to rally further, but unless domestic demand picks up sharply optimism is soon likely to wane.

At the other end of the continent Brazil’s balance of payments outlook appears much brighter. Not only does the country continue to run a pretty substantial trade surplus, but it is also much less reliant on remittances, meaning most capital is received in the form of FDI and portfolio flows. While these flows are potentially much less stable than remittances (for one, unlike remittances they can at least in theory be withdrawn from the country relatively quickly), Brazil’s stronger domestic demand story and diversified export mix means their long-term future seems more certain than in Mexico’s case. Leaving issues such as a potential double-dip downturn in China and the control of rampant capital inflows aside, the contrast with Mexico’s external accounts makes a pretty convincing case for the latter to remain an EM laggard for some time to come.

Se Shang Property Index

Local government demand has been a major driver of property price appreciation over the past year, and giving local officials explicit responsibility for cooling prices should take away a large source of demand as they will discouraged from bidding up land prices to boost land sales revenues. With property prices in first tier cities a long way out of line with incomes and rental yields, and the economy increasingly dependent on real estate construction, a decline in property prices and an economic slowdown in H210 look likely, which could have far-reaching global implications.

If the Se Shang Property Index is anything to go by, real estate prices could be heading down rather quickly. The index peaked in mid-2009 and after selling off aggressively in response to the new lending restrictions, further losses look likely.

Here are some of my thoughts about the implications of the current situation:

• The worst scenario (within reasonable imagination) would be a period of on-again-off-again dust emissions, whereby the all clear is given one week, only to be rescinded a week later, with another all clear issued the following week. This would put travellers and air freight firms in a state of chronic confusion, at least for a few weeks or months.

• Even if the ash cloud clears quickly, but the eruption continues, some would-be passengers may be cautious about immediately booking holidays, lest they end up stranded abroad. Thus, the damage done to the travel industry could easily outlast the dust cloud itself.

• Any extended closure of European airspace would disrupt not only travellers, but a wide range of industries and services that are dependent on moving goods quickly from one