• The main theme of our ratings is the continuing divergence between oil exporters, on the one hand, and oil importers on the other.
• The GCC states and Algeria remain among the most creditworthy sovereigns not just regionally, but globally.
• Our view is largely priced in by CDS and bond markets, but Iraq could be a good relative value play (it scores highly in our ratings owing to a positive medium-term macroeconomic growth story).
• For energy importers, the picture is less positive. Although the risks of ‘Arab Spring’-style upheavals have faded, political and economic risks remain pronounced.
• Recent rallies have brought Jordanian and Moroccan bonds to pre-Arab spring levels, which in our view understates the extent of the risks facing these countries.

Global Commercial Vehicle Segment Outlook

Elsewhere, we highlight our key views on the global commercial vehicle segment; ie vehicles used for business purposes, such as vans, trucks, buses, and coaches.

• We prefer emerging markets (EMs) over developed markets (DMs) as demand in the latter is more related to business sentiment, whereas in EMs demand is being driven by development in infrastructure and heavy industries such as mining and construction (Japan and the US are the exceptions owing to replacement sales).
• Our view on the Indian commercial vehicle segment outperforming the rest of the market played out. Our forecast for 18% growth in sales for the year ended March 2012 was unchanged all year and actual growth came in at 18.2%. Again, growth in construction and mining were contributing factors, as well as favourable diesel prices compared with gasoline.
• Sub-Saharan Africa is one of our favourite regions for new growth opportunities. Kenya stands out as one of the more developed markets, which is attracting investment in domestic production, often for export to other markets in the region.

The stark contrast between Germany and the rest of Europe, especially the peripheral economies, is becoming ever more evident at a time when Germany’s labour market continues to tighten, while Spain’s youth unemployment is hovering above 50%. This comes against the backdrop of Greece – being unable to form a government – planning to hold new elections and EU leaders considering more lenient terms for the country’s budget targets. Moreover, France saw a new Socialist Party president sworn into office today, while Eurostat data show that Italy’s economy contracted by 0.8% q-o-q (seasonally adjusted) in Q1. All of this suggests that pressure on Germany to do its part to help rebalance the eurozone economy is mounting, particularly with French President Francois Hollande meeting with German Chancellor Angela Merkel to push for more growth, rather than austerity.

Our Europe Country Risk team wrote in our Business Monitor Online service today:

[...}we believe that Germany will come under increasing pressure to do its part to help rebalance its economy in a bid to close the gap in competitiveness with the south. This will likely be top of the agenda during the newly sworn-in French President Francois Hollande's visit to Berlin at the time of writing. France's new president has made growth, rather than fiscal consolidation, top of his priority, while German policymakers and central bankers have recently conceded that higher wages and rising inflation should be embraced as necessary.

Most of Europe will likely have viewed Sunday’s election in Germany’s most populous state of North Rhine-Westphalia with a sense of Schadenfreude, as Merkel’s Christian Democratic Union (CDU) was punished at the polls for its pro-austerity stance on local politics.  The CDU endured its worst defeat in this key state in Germany’s post-war history, with the opposition Social Democrat’s manifesto of more spending on childcare going down a treat.

Our  Europe Country Risk team wrote yesterday:

The outcome of the election on May 13 proved far worse for the CDU than recent opinion polls would have indicated. The CDU saw its share of the vote plummet from 34.6% in May 2010, to just 26.3%, well short of the 31% estimated by a recent Infratest dimap poll in late April. The vote was widely seen as a key test of the appeal of the Merkel government’s strict adherence to fiscal restraint and public debt reduction.

Switzerland - 2-Year Government Bond Yield, %

The chart which has really grabbed our attention is the 2-year Swiss government bond yield. The 2s10s spread, which has steepened in recent weeks, could be misconstrued as the market pricing in recovery and firming inflationary expectations. However, this belies the collapse in yields at both the short and long end (with the former dropping further), with the yield on 2-year paper sliding into negative territory. Although financial repression in the form of negative policy rates and government bond yields has been a familiar feature of the post-crisis landscape in Europe, negative nominal yields is far more unique.

US$/EUR Exchange Rate & Euro Net Spec Positions

One of the more damning indictments of efforts by Europe’s politicians to ‘fix’ the eurozone has been the huge build up in net spec positions on the euro. As the chart above shows, net short positions have surged to the highest level since the creation of the beleaguered currency union, underpinning the euro’s slide against sterling and the dollar. Our core view has been gradual and sustained weakening of the euro over the medium term while contra-flows in the form of foreign bund demand and bank fund repatriations would prevent an outright collapse – indeed these dynamics prevented the currency plummeting in 2011, with many hedge fund positions getting smoked in the process. We still broadly hold to this view – sustained weakness but no disorderly collapse – although a potential disintegration of the Franco-German leadership axis or disorderly Greek exit from the currency union, would warrant a more bearish position.

In Greece the two main PASOK and New Democracy parties suffered huge losses, while more extremist parties, such as the Coalition of the Radical Left and the far-right Golden Dawn party made big gains in parliament. The inability to form a government due to the smaller parties’ reluctance to join a pro-austerity coalition, could see political support for Greece’s current bailout package fade and quite possibly end up with the country leaving the eurozone.

In today’s Europe Country Risk service we wrote:

The Greek parliamentary election held on May 6 failed to provide New Democracy and PASOK with sufficient seats to form a credible and workable government. The scenarios from here are bleak. A failure of the previous government partners to broker a deal with a smaller party could see a coalition of radical anti-austerity parties take hold, or more likely a fresh election with an equally uncertain result. Either way, the likelihood of Greece staying inside the eurozone looks ever more untenable.

A Greek euro exit would raise big question marks over the willingness of other peripheral member states to stay in the single currency bloc, and could quite possibly set in motion a chain of events in which the eurozone begins to unravel.

Staying in the Balkans, Serbia held presidential, parliamentary and local elections, in which the incumbent presidential candidate, Boris Tadic, narrowly won a first-round victory, boding well for the country’s longer-term EU ambitions.

In our Business Monitor Online service we wrote:

Although mainstream political parties publicly maintain that Kosovo is an integral part of Serbia, the decline of the ultra-nationalist Radicals, who failed to win a parliamentary seat, and the right-wing Serbian Progressive Party’s (SNS) shift towards the EU, suggests Serbian politics may be slowly becoming less nationalist.

Germany also saw its latest in a string of local elections, in the northern-most state of Schleswig-Holstein, in which the main parties did surprisingly well for a change, and crucially, Chancellor Angela Merkel’s usually trailing liberal coalition FDP managed to hang on to seats in the state parliament. A turnaround in its fortunes? Probably not. Most notably, younger voters from the ruling CDU, as well as the FDP and all of the other major parties, have been flocking to the newly-formed Pirates party, which has obtained the same number of seats as the FDP in Schleswig-Holstein’s state parliament (9). Next weekend’s election in Germany’s most populous state of North-Rhine Westphalia will be a crucial indication for future coalition politics in Germany, in which the opposition SPD and Green party will be looking to secure a majority.

Putin’s Inauguration Overshadowed By Violent Protests

Meanwhile in Russia, Vladimir Putin was inaugurated as president for a third term after four years in which he completed a swap with Medvedev, who today, was sworn in (once more) as Russia’s prime minister. The lavish inauguration, which among other guests featured the former Italian prime minister, Silvio Berlusconi, and former German chancellor, Gerhard Schroder, took place against the backdrop of violent clashes between protestors and police in Moscow.

During his acceptance speech, Putin spoke of ‘national unity’ and how Russia was entering a new stage of national development. Shortly after the speech, the new (old) president signed a flurry of decrees, laying out ambitious economic goals for his government, such as raising labour productivity by 50%, increasing investment to 25% of GDP by 2015 as well as increasing Russia’s ranking in the World Bank’s Doing Business index to 50^th from 120^th at present. 

Our Europe Country Risk team wrote earlier this week:

While we did not expect Romania’s opposition alliance, the Social-Liberal Union (USL), to manage to overthrow the government in a vote of no confidence on April 27, we reiterate our expectation for a USL government to remain committed to the country’s IMF Stand-By Arrangement (SBA).

Judging by the initial market response, Business Monitor were clearly not the only ones to be surprised by the USL’s successful overthrow of the government on April 27. The Romanian leu sold off sharply on the back of this news breaching the key psychological RON4.40/EUR technical level.

Exchange Rate, EUR/RON

Our Europe analysts were quick to highlight:

[The sharp leu depreciation] could have profound implications for the Romanian domestic banking sector, which remains heavily exposed to foreign-currency denominated loans. With around 64% of total loans in the banking system denominated in foreign currency, the latest leu depreciation could prove extremely costly for the country’s already weak banks, should the current weakness persist.

Romania - Benchmark 5-Year Government Bond Yield, %

However, it is Business Monitor’s view that the USL will remain firmly committed to Romania’s existing arrangement with the IMF and will therefore not compromise the country’s longer-term financial stability. Combined with ample foreign reserves, this will likely see the currency stabilise in the near future. Crucially, the Romanian bond market has so far largely brushed off the latest development.

• North Korea will probably want to conduct a new nuclear test (which would be its third) to demonstrate its military power after the failure of its widely-publicised rocket launch on April 13.
• North Korea will also want to test a new nuke for scientific reasons, i.e. to perfect its nuclear weapons technology.

That said, the impact of the nuclear test would probably be limited.

• The East Asia region and wider world have now become accustomed to North Korean nuclear and missile tests. They are viewed negatively, but are not crisis-triggering events.
• There are still doubts about North Korea’s ability to miniaturise warheads to fit them onto missiles, and as evident from the April 13 failed rocket launch, there are doubts about the efficacy of North Korea’s missiles.
• North Korea’s long-term strategy appears to be to build up its nuclear and missile arsenal so that it can negotiate with the US, South Korea, and Japan from a position of strength. Ultimately, it wants normal relations with the US and economic assistance from Washington, Seoul, and Tokyo. However, the major powers are unlikely to reward Pyongyang’s bad behaviour.

Going forward, there are three bigger risks stemming from North Korea’s nukes:

• Pyongyang might feel emboldened to carry out more naval skirmishes against the South, as seen in March and November 2010.
• Pyongyang might pass on nuclear technology to Iran.
• Finally, if North Korea were to collapse, the US, South Korea, and China would have to move quickly to secure the nukes, in case they fell into the hands of rogue commanders or criminal groups.

Exchange Rate, Mexican Pesos Per Brazilian Real

This move is also in line with our take on the two countries’ fundamentals, with the currency risks much more pronounced for Brazil than for Mexico right now. In addition, we believe that the downside risks to Brazil’s economic trajectory are pronounced, whereas we see upside risks to our above-consensus Mexican growth outlook.

MXN/BRL Exchange Rate, Long-Term Chart

The longer-term chart is particularly constructive for the peso, with the unit rapidly approaching 2010 highs against the real, at MXN6.7970/BRL, a break of which would be another bullish signal. Although we still believe that the high proportion of short-term capital in the Mexican economy will keep the peso volatile against the dollar ahead of the July 2012 general election, the technical and fundamental picture against the real remains a strong one.

• Optimal conditions for solar PV: At an elevation of 3,800m above sea level, Xigaze enjoys more than 3,000 hours of solar radiation annually with minimal cloud cover. The average yearly temperature of 6.3 degrees celsius is another positive factor, as it prevents modules from overheating and being damaged, thus eliminating the need for a cooling system.
• Strong government support: The Chinese government introduced feed-in tariffs for solar energy in July 2011 to encourage development of the sector. The FiT in Tibet is CNY1.15 (US$0.18) per kilowatt hour (kWh), which is relatively attractive.
• Decreasing solar PV panel prices: The main constituent of most PV panels is polysilicon, and overcapacity in polysilicon manufacturing has resulted in sharp drops in the price of the material, especially in China. As plant development costs account for the majority of generation costs, decreasing panel prices encourages domestic PV generation growth by allowing solar developers and operators to enjoy higher profit margins.

We believe that China intends to develop Tibet’s tremendous renewable energy potential, and increase its reliance on electricity generated from the province. To date, the government has invested CNY14bn (US$2.2bn) in a Qinghai-Tibet interconnection project that introduces an ultra-high voltage transmission line of 750 kilovolts to improve long-distance transmission between provinces.

These projects indicate the growing importance of Tibet in China’s energy mix, and we expect many more projects to come. As projects are undertaken privately, we see ample opportunities for investors and firms along the PV value chain.

Why Do We Need A Smart Grid?

• In order to meet energy demand growth, improve efficiency and meet climate change obligations.
• Conventional grids are unable to handle more complex energy dynamics, particularly unpredictable sources like renewables.
• In the smart grid, supply is realigned with demand using two-way communication, allowing more advanced energy management, greater grid efficiency, lower electricity consumption and lower emissions.
• The smart grid enables greater integration of renewables in the energy mix and improves efficiency.

Why We Might Not Want A Smart Grid

Security: A connected grid means vulnerability to cyber-attack, creating a national security issue as the grid is critical infrastructure.

Privacy: The granularity of data collected raises issues of who owns the data and what purposes it can be used for.

• If regulations are incomplete, data may be sold to third parties without prior consumer consent.
• If this risk is not actively managed by regulators, there is potential for a breakdown in consumer trust, potentially undermining the functioning of the smart grid, which relies on consumer participation.

Find Out More

BMI is increasing its coverage of renewables over the course of 2012, and beyond.

New Format

• The forecasts cover six refined products across three regions.
• We forecast the global average price for each product over the next five years.
• The forecasts are driven and guided by BMI’s Shipping, Autos, Petrochemicals and Macroeconomic views.
• The latest update introduces bunker fuel forecasts.

Key Views

• Refining: A cyclical downturn is in play; so too is geographical restructuring of the industry in the US. Refining is in decline in Europe, but there is growing refining capacity in emerging economies.
• Petrochemicals (Naphtha forecast): The spread between naphtha products and crude benchmarks is relatively small, which implies that crude feedstock costs for refining and petrochemicals are the same, and therefore, the cyclical trends are the same.
• Aviation & Shipping (Kerosene & Bunker Fuel): Fuel costs are high and trade volumes are falling; 2012 is set to be another difficult year.
• Gasoline: There is much demand destruction in play (due to more fuel-efficient cars and fewer car journeys), so prices have probably reached a peak which they will struggle to sustain.
• Diesel/Gasoil: Demand is growing (diesel is more fuel-efficient and environmentally friendly than gasoline), while supply is declining (many of the refineries that were shut in recent months were in diesel markets such as Europe). There is a potential for upward price movement this year.

In conclusion, 2012 is set to be a difficult year for both refiners and their customers.

While almost all of Mélenchon’s and Eva Joly’s votes are likely to be transferred to Hollande in the second round, similar dynamics should not be assumed between Le Pen’s votes and Sarkozy. High voter abstention in the second round from marginal candidates means suggests Sarkozy is unlikely to garner enough momentum to win a second term in power. Last time we discussed the French presidential election on Risk Watchdog, we highlighted our concerns over the future of Franco-German partnership and the future direction on the eurozone rescue process. We expand upon this risk in greater detail in our analysis on Business Monitor Online:

Coming to power on a mandate to pursue growth and employment, we expect Hollande would keep the pressure on Berlin to adjust its prescription of austerity-related policies to include greater emphasis on growth plans. While this is in line with our Global team’s long-held view that austerity on its own would prove self-defeating without plans to generate economic growth, we highlight that there is significant scope for near-term volatility if markets begin to fear that eurozone countries will loosen their fiscal constraints before making the necessary reforms needed for long-term competitiveness.

Indeed, we expect eurozone sovereign debt markets could turn increasingly choppy, posing future problems for sustainably funding France’s sovereign debt load should yields stay substantially elevated:

The spread of French 10 year OATs over German 10 year bunds was trading at 140 basis points on April 23 – the highest since January – and we expect this could head as high as 200 basis points should confidence deteriorate.

• Inflation in the Gulf Co-operation Council (GCC) economies is heading higher over the coming years. High oil prices, heavy government spending, loose monetary policy, elevated international commodity prices, and bottoming out housing markets all suggest that prices are going to rise steadily.
• However, we do not expect to see a repeat of the double-digit inflation seen in the run-up to the global financial crisis in 2008. Given oversupplied housing markets, it is difficult to see how another property market bubble could form. Meanwhile, governments are more concerned with the inflation problem now – and have responded by subsidising consumer goods and issuing debt to mop up excess liquidity. These factors should prevent a major spike in inflation.
• Nevertheless, higher prices will be a problem in the coming years, weighing on real GDP growth and making the region’s business environment even less competitive.

Elsewhere, we ran an article on the challenges facing Iran’s auto sector, as it aims to become more self-sufficient in the face of international sanctions:

• Iranian carmakers such as IKCO and SAIPA have been reasonably successful over the last couple of years in producing ‘national cars’ and engines to reduce reliance on foreign companies.
• The possible full withdrawal of Peugeot will provide one of the biggest tests for the industry, as it has had a long-standing partnership with IKCO, but GM’s proposed involvement with PSA Peugeot Citroen makes a withdrawal more likely.
• Demand for premium imports has been hit by restrictions on foreign currency, and we believe it will be tough for domestic brands to provide an alternative to these high-end imports.

Read more about these developments, and other topics of importance in the Middle East, on Business Monitor Online.

Our reasons for the revision are as follows:

• We believe that the monetary conditions that aided construction activity are going to end. The government is planning to decrease fuel subsidies (i.e. raise fuel prices) over the course of 2012. This would mostly likely lead to a surge in inflation, forcing the Indonesian central bank to shift back towards a hawkish monetary policy.
• Key regulatory reforms have also failed to transpire over the past quarter. The land acquisition bill, approved by the Indonesian parliament in December 2011, still has not been signed by President Susilo Bambang Yudhoyono, suggesting a lack of political will and a lack of institutional capacity to complete the bill.
• Besides the land acquisition bill, the Indonesian government has chosen to bow to public pressure and approve a proposal to indefinitely delay a 10% hike in power prices for 2012. This decision is a negative signal for the private sector to invest in new generation capacity as the elevated cost of energy is already squeezing profit margins for independent power producers throughout Asia.

Full coverage and analysis of global infrastructure developments can be found on Business Monitor Online.

Rather than addressing Argentina’s dearth of productive capacity and increasingly overvalued currency, the nationalisation of YPF will simply exacerbate the problems currently facing the economy. For starters, although it is not clear how much the government will pay Repsol for a controlling stake in YPF, some money is likely to change hands, and since this will probably come from foreign reserves, it will further reduce Argentina’s reserve buffers. More important, in our view, is the effect the takeover will have on investor sentiment, which has already been damaged by the government’s imposition of capital controls.

Spread Between Official And 'Blue-Chip' ARS/US$ Exchange Rate

Both factors will increase downward pressure on the official exchange rate, which remains extremely overvalued in real terms. With the spread between the official ARS/US$ exchange rate and the ‘blue-chip’ rate, which we use as a proxy of the market-implied exchange rate, continuing to push on to record highs, something will have to give. Since we do not expect a change in policy trajectory anytime soon, this increases the likelihood of a destabilising devaluation in the official exchange rate at some point over the next few years. In short, the outlook for foreign firms operating in strategic sectors will remain highly precarious.

Gold Prices, US$/oz

Key Takeaways

• We do not think that the ten-year bull run in gold prices is over, although we will lower our 2012 forecast from US$1,850/oz currently.
• Risks are weighted to the downside. If the US economy does not lose a little steam in the coming months as we expect it will, then QE3 could get completely priced out and gold prices would get hit.
• There are upside risks, in particular a return of eurozone break-up fears. Although eurozone turbulence would be negative for gold in the short term (dollar strength, widespread liquidation of assets), it would be bullish for gold in the long term. The European Central Bank would be forced to ‘print’ more money. Gold will remain an attractive liquidity play in the context of currency debasement.

China’s real GDP growth came in at 8.1% y-o-y and 7.2% q-o-q on a seasonally-adjusted annualised basis in Q1 2012, according to data released on Friday April 13. This was much weaker than consensus expectations. Unlike the situation facing the economy in Q1 2009, when a recovery in exports combined with a fiscal stimulus programme resulted in a V-shaped recovery, this time around we expect continued lacklustre growth even as the central bank is likely to loosen monetary policy.

While Q2 2012 could see a slight bounce in GDP growth as the trade account returns to surplus and Purchasing Managers’ Index (PMI) figures stabilise, the longer-term growth slowdown is by no means over. As such, our core view of a ‘hard landing’ is unchanged, and we are sticking with our 7.5% real GDP growth forecast for 2012. We continue to believe that interest rates cuts will be forthcoming at some point in 2012 as inflationary pressures moderate. The ‘miss’ in the Q1 2012 growth figure could in fact signal that monetary easing will be forthcoming in the near term. Despite the recent uptick in CPI, we continue to see price pressures abating over the coming months, paving the way for two 25 basis points interest rate cuts, taking the one-year lending rate down to 6.06%. However, there is only limited scope for fiscal stimulus.

North Korea: How To Destroy 3.2% Of GDP In Two Minutes

Meanwhile, North Korea’s closely watched Unha-3 rocket failed after about two minutes’ flight time on Friday, in what was an extremely embarrassing setback for Pyongyang. Surprisingly, the North’s official media admitted the failure of the rocket. This is an extremely unfortunate event for the newly inaugurated leader, Kim Jong Un, who received new party and state posts this week. The rocket launch also virtually coincided with the centennial of the birth of Kim’s grandfather and the nation’s founder, Kim Il Sung. There is now growing speculation that Pyongyang will carry out a new nuclear test or naval skirmish to make up for the rocket blunder.

There is also an economic cost for the regime. South Korean officials estimate the cost of the rocket launch at US$850mn, which would be the equivalent of 3.2% of the North’s 2010 GDP, as calculated by the South’s central bank. The US$850mn figure is also sufficient to feed 79% of the North’s population for one year.

Turning to more serious matters, a key consequence of the French presidential election will be the future of the Franco-German partnership, which is the core of the eurozone and the European Union. It is becoming increasingly clear that France is no longer Germany’s equal. An open break between Berlin and Paris would be extremely destabilising for Europe’s fiscal compact, and thus the future of the eurozone.

If Hollande follows through on his plans to renegotiate the fiscal compact, we see two potential risks emerging. A move by France away from fiscal austerity could politically isolate Germany, and potentially herald a major shift in the eurozone rescue dynamic towards a more growth-oriented bailout plan. In addition, Hollande’s intervention could trigger volatility in the eurozone, potentially resulting in a sustained bout of risk aversion as investors reassess their expectations of the single-currency area’s stability.

We discuss these issues in more detail in Business Monitor Online.

North Korea Preparing To Inaugurate Kim Jong Un

On Wednesday April 11, North Korea’s ruling Korean Workers’ Party (KWP) is scheduled to hold a rare conference, and on Friday April 13 the country’s Supreme People’s Assembly (SPA, the ‘rubber stamp’ parliament) will hold its annual session. It seems all but certain that North Korea’s new leader, Kim Jong Un, will use these two events to formally take charge as head of the party and the state. We would also expect a reshuffle of party and government posts as Kim inaugurates his rule.

Another important date to watch is April 15, which marks the 100^th anniversary of the birth of Kim’s grandfather and the country’s founder, Kim Il Sung (curiously it is also the centennial of the sinking of the Titanic). As I type this, North Korea is preparing to launch a new satellite-carrying rocket, although critics argue that this is the same as conducting a missile test. There are also reports that North Korea is planning a third nuclear test. All this goes against a moratorium on missile and nuclear tests that the North announced in late February. The speed with which Pyongyang has changed tune since then demonstrates the unpredictability of the regime.

Overall, there is very little the outside world can do to prevent North Korea from carrying out missile and nuclear tests. However, there is a possibility that Pyongyang may moderate its stance after the all-important inauguration of Kim Jong Un, the centennial of Kim Il Sung, and the April 25 80^th anniversary of the founding of the North Korean military. These events have long been recognised as symbolically important, and thus occasions for military bravado.

South Korea’s Elections Bellwether For Presidency

Meanwhile, South Korea will hold parliamentary elections on Wednesday, April 11. The ruling conservative Saenuri (‘New Frontier’) Party is struggling to retain control of the National Assembly (parliament) amid a strong challenge from the opposition Democratic United Party (DUP), and opinion polls point to an extremely close race. While the legislative elections are important in their own right, they will also be closely watched as a bellwether for the presidential election to be held on December 19. Saenuri leader Park Geun-hye, who is already the frontrunner, is hoping that a strong showing will secure her path to the Blue House, while Moon Jae-in, chief of staff of former president Roh Moo-hyun, is hoping to emerge as the DUP’s candidate.

South Korea’s current president, Lee Myung-bak, is not eligible for a second term, so there will certainly be a new president taking office early next year. This could pave the way for an improvement in North-South relations, which deteriorated markedly under Lee’s hardline policies. Park and DUP leaders have advocated a more conciliatory policy towards Pyongyang, and while the latter’s provocations may make this harder to justify in the near term, tensions may have calmed somewhat by December 2012. Nonetheless, there are limits to the North’s scope for friendliness towards the South, as it will not give up its nuclear arsenal. Furthermore, hostility towards Seoul (and Tokyo and Washington) appears to be hardwired into Pyongyang’s worldview.

Household Savings Rate, %

Though this may seem like the easier option for politicians of the core states (i.e. Germany), continued balance sheet expansion by the ECB will increasingly stoke inflation, which in a country with a high savings rate is unlikely to go down well. Moreover, with the euro being a far cry from the stability of the Deutschmark, German households may increasingly find themselves dogged by growing inflationary pressures, especially with oil prices trading near current levels.

German Inflation And Unemployment Rate, %

This is likely to see a major shift in the balance of power between German employers and trade unions. The latter have quietly accepted a cap on wage increases and longer working hours in recent years, in favour of greater job security, further boosting Germany’s economic competitiveness vis-a-vis the South. However, there are now signs that unions are no longer willing to idly sit by and watch the labour market tighten, the inflation rate accelerate, and wage demands remain unmet. March 27 already saw a wave of warning strikes across Germany, affecting nine airports. There is a good likelihood that another wave of industrial action could be around the corner, and wage negotiations for 2012 and 2013 are unlikely to be easy for employers, particularly in the public sector.

Our Europe Country Risk team recently wrote in Business Monitor Online:

We see a high likelihood of major industrial action throughout the month of May, as demands for higher wages are gaining momentum. Having enjoyed a period of considerable bargaining power and an uncertain economic outlook, we believe that German employers are likely to come under growing pressure to accelerate wage adjustments over the course of 2012 and 2013.

Higher wage increases and inflation in Germany may actually help to accelerate the eurozone’s economic rebalancing process:

It has long been our view that the eurozone crisis will need to be resolved internally and that a rebalancing will require as much adjustment on the part of Germany and other current account surplus economies, as is currently being asked of the peripheral current account deficit countries. It is impossible for every country in Europe to pursue a current account surplus, and by allowing more pronounced wage increases over the coming years, this could go a long way in helping the overall rebalancing process required to preserve the existence of the euro.

It’s early days, however, and while higher wage increases in Germany look likely, this alone will not take care of Europe’s problems. After all, the lack of direct transfers from the North to the South will begin to see savings from the core eroded, while peripheral countries will be required to stay the course of fiscal austerity. This could create some unpleasant social and political dynamics over the coming years.

The latest developments follow hot on the heels of BMI’s recent special report, Myanmar Awakens: Unearthing Asia’s Hidden Gem, where we predicted a strong showing for the NLD and discussed the effects of the by-elections on Myanmar’s investment prospects. Thus far, the results appear to mark a watershed moment in the country’s recent reform drive, with positive implications for both the political system and the state’s improving relationship with the international community.

Investors will be particularly interested in whether or not EU and US economic sanctions will be lifted. While a timetable is still hard to pin down, we would expect sanctions to be drawn down incrementally over the course of the coming year. What we can say is that the by-election results appear to be very positive, and a major potential obstacle to the removal of sanctions has now been lifted.

Regarding the world’s main trouble spots, our core views are as follows:

• The eurozone will most likely ‘muddle through’ its crises.
• Conflict with Iran remains the biggest single global political risk. However, we think this is not inevitable, and that Israel/US will hold off on airstrikes in 2012. From 2013, risks could rise sharply.
• Syria’s conflict has reached a deadlock. President Bashar al-Assad may last longer than we expect (i.e. beyond the end of 2012).
• The West’s war in Afghanistan is winding down, without a clear-cut victory for either the West and its Afghan allies, or the Taliban.
• North and South Korea are in political transition, and there is still a risk of Northern provocations.

Our other key country views are as follows:

• USA: Barack Obama has a good chance of being re-elected.
• Mexico: The opposition PRI party will win the presidency and congressional elections in July, boding well for reform of the state oil monopoly Pemex.
• Venezuela: There is a very high risk of instability in the run-up to and in the aftermath of October’s presidential election.
• France: Socialist Francois Hollande will probably defeat President Nicolas Sarkozy in the April-May election, although Sarkozy is rapidly catching up in polls. The outcome is crucial for the Franco-German axis of the eurozone.
• Greece: Extremist parties are polling well ahead of spring elections.
• Egypt: May’s presidential election will mark the transfer of power back to civilians. However, it is still unclear who will win the presidency at this stage.
• China: A new generation of leaders will take power between autumn 2012 and March 2013. The recent dismissal of Chongqing city leader Bo Xilai suggests that the Communist Party may not be as stable as previously believed.
• Myanmar: All eyes will be on whether the country continues to liberalise after by-elections on April 1.

Our Global Political Outlook elaborates on each of the above points, and more.

As always, the Global Political Outlook concludes with a list of possible ‘wild cards’ that could transpire. Essential reading.

Private consumption will remain the main driver of growth in 2012, supported by aggressive monetary easing (the central bank has cut the Selic rate by 275 basis points (bps) since August 2011) and we anticipate another 100bps of cuts before year end, as well as tax cuts on staples and durable goods (which were just extended this week until June 30) to support private consumption.

On the fixed-investment side, we see strong growth potential in both the infrastructure and oil and gas sectors. Our Oil & Gas team forecasts Brazil to see a significant pick up in oil production in the coming years, as offshore production comes on line. Meanwhile, growth on the infrastructure side will be driven by the government’s growth acceleration programme, construction in advance of the 2014 World Cup and 2016 Rio de Janeiro Olympics, as well as continued efforts to close the country’s infrastructure deficit.

That said, we are below consensus on growth in 2013 at 3.7%, as we believe that Brazil’s structural economic imbalances – namely a strong consumer and a weak manufacturing sector – will begin to unwind. We see this happening through a gradual weakening of the currency beginning in late 2012, though a more rapid unwind of these imbalances remains a major downside risk to our view.

The highlights are as follows:

• The ECB has grown from 10% of the eurozone economy to more than 30% today. It is bigger than the US Federal Reserve and the Bank of England as a percentage of GDP, and it will get bigger still.
• The ECB will get bigger because Europe’s politicians are not reforming fiscal and economic institutions fast enough to tame the crisis, leaving the ECB as the only institution with sufficient capacity to prevent the eurozone from disintegrating.
• This current period of tranquillity could prove the calm before another storm.
• If economic imbalances are addressed, public finances overhauled (through fiscal union, Eurobonds, etc) and GDP growth potential restored, then the expansion of the ECB would prove temporary.
• If these issues continue to be deferred, then the ECB will remain under pressure to keep governments and the banking system on life support. That there has been little tangible progress in the political sphere during the first quarter of 2012 despite the eurozone coming close to meltdown in 2011 certainly does not inspire confidence.
• If the ECB continues to expand, it could come to dominate the markets for sovereign debt and bank funding. We examine the implications for prices, sovereign debt and the long-term solvency of the central bank.

The full article is available to subscribers at Business Monitor Online.

Myanmar’s recent rapprochement with the West and its tentative signs of political and economic liberalisation have fuelled hopes that the country is finally emerging from decades of isolation to join the ranks of Asia’s economic powerhouses. Many hope that Myanmar will now emulate the success of countries such as Thailand and Vietnam.

In our special report, we discuss:

• The political and geopolitical factors driving and constraining Myanmar’s reforms
• The economy’s strengths, weaknesses, opportunities, and threats
• The outlook for a variety of industries, including infrastructure, oil and gas, and consumer sectors
• The challenges faced by investors as a result of Myanmar’s business environment

BMI’s Head of Asia Research, Rahul Ghosh, notes that the report showcases:

• The extent and sophistication of BMI’s frontier markets coverage
• BMI’s application of total analysis – politics, macroeconomic development, microeconomic environment, and markets – even in a country as isolated as Myanmar
• BMI’s ability to produce a top-quality special report on key issues of regional or global significance

We believe that our special report on Myanmar is probably the most comprehensive and insightful of its kind available at the present time. The report, along with our other recent special reports, can be purchased from the Business Monitor Online Store.

At the time, this was regarded as a highly risky move on her part and one that Merkel was not particularly fond of, considering that the CDU had just survived a year in which it took quite a beating across a string of state elections. However, the gamble has undoubtedly paid off and sends a strong signal: the focus on prudent fiscal policy and the so-called ‘debt brake’ is going down well with German voters. Merkel’s CDU now faces another two tough tests with state elections coming up in Germany’s northernmost state of Schleswig-Holstein on May 6 and more crucially in the all-important state of North-Rhine Westphalia on May 13.

For full coverage and analysis of Germany’s political developments, please visit Business Monitor Online.

Consensus had been for PMI to rise to 49.5. Composite eurozone PMI, which includes service sector activity, fell from 49.3 in February to 48.7. Taken together, such data suggests that although the European Central Bank has successfully stabilised the eurozone’s financial sector, the macroeconomic recovery will be slow to materialise. A second quarter of negative economic growth looks fairly likely for the eurozone, and we forecast the bloc’s economy to contract by 0.5% over the course of 2012.

The HSBC manufacturing PMI reading out of China was similarly discouraging, coming in at 48.1 as opposed to February’s 49.6 print, and we reiterate our view of monetary policy easing by the People’s Bank of China over the course of 2012. In the meantime, equity markets globally are coming under pressure, with weakness looking set to prevail in the near term – a development which would be far from surprising, given the strong move higher in recent months.

After stripping out the seasonal effect of the Chinese New Year, the Asia-Pacific region’s major exporters continue to see a slowdown in export growth. However, we have started to see tentative signs of stability – improvements in new exports orders in purchasing manufacturers’ indices (PMI) are a positive sign. Nonetheless, at this stage, we are opting to maintain our conservative real GDP growth forecasts for the region, because significant risks, stemming mainly from the potential for financial market instability, continue to cloud the outlook.

Brazil: Growth Implications Of A Weaker Real

Elsewhere, the Brazilian real broke below multi-month trendline support on March 20, although the unit had pared its losses towards the end of the trading day. The real is also fast approaching key long-term support on the monthly chart, and as we have been pointing out consistently over the past few months, a sustained break of the BRL1.900/US$ support level would indicate a reversal in the unit’s decade long appreciatory trend.

Although depreciation should help with economic rebalancing over the longer term, we believe the potential risks to Brazil’s growth story remain largely under-appreciated. In our article, we identify three main risks to growth that would play out over the coming quarters: a significant reduction in purchasing power and hence a weaker consumer story; potential for significant banking sector stress; and a reemergence of inflationary pressures.

YPF rejected the charges and said it would take ‘the appropriate legal steps to defend its rights’. The company pointed out that it had increased its reserves in the region by 24% since 2007. The company also says it has invested US$350mn in its field in the province in 2011 alone, a 236% rise from 2009. According to the firm, this has lead to a 14% increase in completed wells, which is an 83% rise from 2007, and a 2.6% boost to the total production in the province in the past four years. The revocation could take 60 to 90 days to complete. El Trébol accounts for 5.2% of Chubut’s production and CCBVCP for 2.9%.

In a separate but related matter, the state news agency Telam said that YPF, Royal Dutch Shell  and  Esso, a subsidiary of ExxonMobil, had been ordered to put a price cap on jet fuel charged to airline companies with airplanes registered in the country. Telam’s release said that the ‘the price of a litre of JP1 jet fuel must not exceed ‘super’ gasoline by more than 2.7% from the price charged at a gas station nearest to the airport where it is loaded’. YPF is the main jet fuel supplier in the country. President Cristina Fernandez said in February 2012 that ‘nearly all the JP1 is produced [in Argentina], with the exception of very small amount that is imported, which I think they do to justify charging us the international price’. The antitrust commission said that the companies were charging jet fuel 47% higher than super gasoline, comparing it to the US where it deems it to be 2.1% higher.

Trying To Bring The Valuation Down

Heavy pricing regulation and an unwelcoming tax regime have led to a chronic underinvestment in Argentina’s oil and gas industry, which peaked with the 2004 energy crisis. The authorities tried to reverse this trend in 2008 with the launch of ‘Gas Plus’ and ‘Oil and Refining Plus’. Under the programme, firms were entitled to sell output from new and unconventional fields above the prevailing state-set prices; it also provided fiscal incentives to boost production and reserves.

However, instead of moving towards further liberalisation of the sector, Argentinean authorities have backtracked on past reforms. The decisions come at a time when there is large capital flight from Argentina’s financial system, with an estimated US$3bn leaving the country each month – draining the central bank’s reserves. In October 2011, a new measure was introduced forcing oil and gas companies to hold 30% of all exports for domestic use. On February 3 2012, the ‘Oil and Refining Plus’ programme was suspended.

There have also been growing rumours of a possible nationalisation of YPF, which was privatised and bought by Spain’s  Repsol  in 1999. The concessions that were revoked and tighter regulation in end-user pricing are likely to bring the valuation of Repsol’s 57.43% stake in the firm down. Considering similar moves in other industries, the government notably nationalised the country’s US$24bn pension fund industry, we believe that the nationalisation of YPF is increasingly likely to take place.

Sovereignty over oil exports would surely boost the country’s balance of payments in the short to medium term. Furthermore, YPF’s recent discoveries in the Vaca Muerte formation of the Neuquén shale, which put contingent resources around 1,525mn barrels of oil equivalent (boe), suggest significant upside risk to exports. Our forecasts, which have yet to include these resources, due to the lack of reliable data on future production, see exports of 87,000 barrels-a-day (b/d) in 2011 becoming imports by 2016.

However, despite the government’s belief that it might be able to develop shale resources without much help, evidence suggests to the contrary. YPF estimates it would take US$42bn of combined investment from all stakeholders, the drilling of 3,000 producing wells and the addition of 100 new rigs (the country currently has 80 rigs in play) to develop the Vaca Muerta play. The company said that in order to double the country’s current oil and gas production, it would take US$25bn per year to develop all existing prospective resources.

It therefore remains unclear whether YPF will be nationalised, but recent announcements suggest that the government has decided to undermine the company’s valuation. Therefore, we see the nationalisation as increasingly likely. This offers a very negative outlook for the country’s oil and gas future and for foreign investors.

A Nuclear Iran Would Mean A Different World

Meridor stated that the nuclearisation of Iran would mean a ‘different world’. He identified three ways in which this would make the region more dangerous:

• A regional nuclear arms race would ensue.
• Some of Iran’s neighbours would be forced to align with Iran out of fear.
• Extremist religious groups in the region would be emboldened by a nuclear Iran.

Meridor outlined how Iran’s fierce rhetoric likening Israel to a ‘tumour’ in the region frightens the Jewish state, but he also pointed out that most Arab countries want Iran to be prevented from acquiring nuclear weapons. On that subject, he noted that even though Arab states came to regard Israel as a nuclear power decades ago, they have largely refrained from seeking to go nuclear. The implication is that Arab states are more uncomfortable with a nuclear Iran than a nuclear Israel.

Meridor refused to identify red lines or deadlines that could trigger military action by Israel. He also refused to speculate about the impact of an Israeli strike on Iran’s domestic political situation. However, he emphasised that Israel’s fears of Iran stem from its regime rather than the Iranian people, noting that prior to the Iranian Revolution of 1979, the two countries had enjoyed good relations stretching back to the ancient Persian king, Xerxes, who had a favourable attitude towards Jews.

Israeli fears of Iran’s rhetoric are exacerbated by the fact that Tehran acts on its words. He cited attacks against Israeli diplomatic personnel in Georgia, India, and Thailand in February 2012, which he blamed on Iran’s Islamic Revolutionary Guard Corps (IRGC)’s Qods force, under the command of Qasem Soleimani. Furthermore, given that pro-Iranian groups attacked Israeli targets as far away as Buenos Aires as far back as 1992 and 1994, Meridor believes that Iran would strike against Israeli interests abroad, in the event of conflict.

Meridor was asked if nuclear proliferation fears could be assuaged by the creation of a Middle East nuclear-free zone, one in which Israel too would denuclearise and subject itself to international inspections. He maintained Israel’s long-standing position of neither confirming nor denying its possession of nuclear weapons, but also raised the question of why denuclearisation should be limited to the Middle East. However, Meridor fears that there would be a high risk of participants of a nuclear-free zone violating agreements.

When asked if there is anything that Iran can do to soothe Israeli concerns, Meridor suggested that Tehran also needs to convince Arab countries of its good intentions. But he also clarified that Israel needs verification that Iran’s nuclear programme is not being used for military purposes, through intensive inspections and monitoring. On the subject of whether sanctions and cyber warfare can force Iran to back down, Meridor seemed to think that Iran does occasionally bow to realpolitik and reason. He cited Iran’s acceptance of an internationally mediated settlement to end the Iran-Iraq War in 1988 (although we note that this only emerged after eight years of war and hundreds of thousands of casualties). Meridor also pointed out that unlike North Korea, which seems content to live in an autarkic bubble, Iran was too sophisticated a society to accept living in isolation.

While Meridor had nothing to say about China’s possible role in resolving the nuclear stand-off, he stated that Russia needs to do more to pressure Iran and Syria to comply with international demands. India, too, needs to consider pressuring Iran; New Delhi is in a unique position, because it is a friend of Israel that is also friendly with Iran.

Finally, when asked whether a nuclear Iran was preferable to a regional war (resulting from military action to prevent Iran from going nuclear), Meridor unsurprisingly said that both were highly undesirable outcomes, but that a nuclear Iran would be a game-changer, because it would give Iran greater freedom of action by making it feel ‘untouchable’.

The Arab Spring: Still Early Days

Meridor freely admitted that neither Israeli nor other foreign intelligence agencies saw the Arab Spring coming, and that if told on January 1, 2011 what lay ahead, most of them would have found the idea unbelievable. Subsequent events showed that more humility is required in forecasting. Meridor noted that the Arab Spring is still in its early days, and that while most of the slogans in Cairo’s Tahrir Square promoted Western ideas, political Islam is evidently rising. Tunisia’s transition seems to be proceeding smoothly, but Meridor wonders what sort of Egypt will emerge after the 2012 presidential election. For Israel, the future of the 1979 Israel-Egypt peace treaty is of paramount importance, for it has prevented hostilities between the two countries for more than three decades (Jordan is the only other Arab state to have a peace treaty with Israel, signed in 1994). Overall, Meridor is hopeful that the Israel-Egypt peace treaty will stay the course, noting that Egypt has no real interest in conflict with Israel. While he recognises dangers in the new Middle East, he also sees opportunities for more Arab countries to quietly increase their contacts with Israel, especially because of their mutual fear of Iran.

Syria: A Key Ally Of Iran

Meridor outlined three reasons why events in neighbouring Syria are of concern to Israel. Firstly, there is the humanitarian aspect of attacks on civilians in Syria. Secondly, Israel wonders who or what will come after President Bashar al-Assad. Thirdly, because Syria is Iran’s only real ally in the Arab world, a break in the Iran-Syria-Hizbullah alliance would probably improve Israel’s security.

The Palestinians: New Negotiations Needed 

Because he devoted so much time to discussing Iran, Meridor did not say much about the Palestinian issue. He feels that while the lack of negotiations is bad for Israel, this is not necessarily good for the Palestinians. Meridor does not see their relationship as a zero-sum game. However, the decline of the Palestinian Liberation Organisation (PLO) and the rise of Hamas has complicated matters, because Hamas, like Iran, believes that Israel should not exist.

Pictorial Packaging

According to Houts et al (2006),using images to convey healthcare information improves attention, comprehension, recall and adherence to treatment, especially in poorly educated or illiterate patient samples.

Combating Counterfeiting And Cold Chain Issues

BMI has previously highlighted the importance of holograms, text message authentication and radio frequency identification (RFID) systems to protect pharmaceutical distribution channels. Packaging also needs to draw greater attention to sell-by dates and correct storage conditions.

Advertising

While BMI thinks regulations should be tightened to prevent ‘snake oil peddlers’ putting the health of the population at risk, the weak regulatory environment in many developing countries also presents opportunities for drugmakers to build their brands through direct advertising to patients.

Halal Medicines

Drugmakers are always looking for competitive marketing advantages, be it by reducing side-effects, accelerating drug delivery, improving efficacy or even complying with religious guidelines. In this final respect, seeking halal certification seems to be a relatively cost-effective way of gaining a competitive edge when selling products to the world’s 1.57bn Muslims, who are based primarily in the emerging markets of Asia, the Middle East and Africa.

Muslims must ensure that all food, pharmaceuticals and non-food items such as cosmetics are halal, which translates as ‘permissible’. Pharmaceuticals frequently contain ingredients that are not permissible for Muslims such as alcohol and animal by-products such as gelatine. Furthermore, the rapid development of biopharmaceutical products can also be controversial, especially if the resulting medicines are derived from blood or blood-related products. There are allowances in Islam for the taking of these medicines if there is no alternative, but if a drugmaker creates a halal product it could rapidly increase its market share, particularly in the OTC segment of the market.

The UK is already fairly unique in that there are liquid 50-year benchmarks, unlike the US where the longest maturity is 30 years. Having gone cap in hand to the IMF in 1976 to secure a bailout from the IMF, civil servants in Whitehall subsequently sought to establish liquid long-dated bonds to alleviate future financing difficulties, resulting in a weighted average maturity today which is the largest among developed states (13 years compared to an average of six for developed economies). 50-year nominal bonds currently yield around 3.3%, while the Debt Management Office (DMO) also sold GBP4.5bn worth of 50-year inflation-linked debt in October 2011. This was oversubscribed (with bids of GBP9.8bn) and represents the longest-dated indexed bond in the world.

The concept of extremely long dated bonds and perpetual instruments (which the government is also considering) is by no means a novelty. The first such bonds were issued in the early 19th century, with a bond issued in 1853 to manage the debt legacy of the 1720 South Sea Bubble still in existence. According to (DMO), there is also GBP1.9bn left over from the 1932 bond which was sold to cover the cost of the First World War.

Will it work? ‘Super Gilts’ or ‘Osborne Bonds’ (as they have already been described) would certainly bolster the government’s ability to manage the national debt. Fiscal consolidation and debt pay- down, financial repression and extension of the yield curve all feed through into an orderly public sector deleveraging over the longer term. But potential buyers need to assess whether the security of locking in long-term yields outweighs the potential for higher yields down the road, as the inevitable economic recovery and inflation eventually take hold.

Dodson told Reuters: ‘The UK side of the North Sea has generated an awful lot of oil and gas, and I still think there could be potential for making some fairly significant discoveries there.’ Dodson added that he was not sure whether the ideas and techniques used to uncover NCS fields such as the giant Sverdrup, which is thought to contain between 2.2mn and 2.8mn barrels (bbl) of oil, were yet in use in the UK North Sea.

New Interest And Strong Investment

Statoil is not the only company looking at UK North Sea assets. Interest in new licensing rounds has been very healthy with the UK’s latest resulting in a total of 190 awards covering 2,818 blocks. A further round, covering 2,800 blocks was offered up on February 1 2012, with the deadline for applications set for May 1 2012. The strong response indicates that the UK North Sea is still capable of drawing exploration and appraisal (E&A) interest, especially in underexplored regions such as the West of Shetland (WoS).

Upstream investment as a whole is also on the rise, hitting a record GBP7.5bn (US$11.5bn) in 2011, according to data from Wood Mackenzie. That number is expected to rise further in 2012 on the back of a number of flagship projects in the WoS area funded by international oil companies (IOCs) such as BP and Total.

There May Be Trouble Ahead

At first glance, therefore, the prospects for the UK North Sea appear rosy. However, there are also some worrying signs. The number of new exploration wells drilled in 2011 fell by 34%, according to consultancy Deloitte. The fall came as a number of independents reduced E&A activity in a bid to channel capital expenditure (capex) into boosting recovery rates at existing fields in order to take advantage of high oil prices.

Many independents also argue that Chancellor George Osborne’s raid on the industry in his 2011 budget, in which he raised the supplementary charge on oil and gas production from 20% to 32%, has hit E&A investment. Rising capital costs and changes to the rules relating to the decommissioning of existing oil and gas infrastructure are also thought to be putting pressure on the balance sheets of smaller explorers – reducing scope for upstream investment in mature basins.

Thus, while the immediate outlook for the UK oil and gas industry looks healthy, there could be trouble further down the road. Perhaps most worryingly, the long-term decline in UK reserves is likely to quicken if drilling activity continues to slow. Production has also fallen markedly despite the drive to monetise existing resources. UK oil and gas output fell 18% in 2011 to 1.8mn barrels of oil equivalent a day (boe/d), according to industry body Oil and Gas UK. Our colleagues at Business Monitor anticipate oil production of 1.2mn barrels a day (b/d) and gas output of 55bn cubic metres (bcm) in 2012. We expect that oil and gas production will fall towards 955,000b/d and 48bcm respectively by 2016.

A Mixed Bag

The outlook for the UK North Sea is therefore very mixed. Strong investment and interest in new assets is clearly encouraging but it merely confirms the existing dichotomy between burgeoning IOC investment in greenfield developments and reduced E&A capex in mature basins where independents dominate. Given that these smaller operators make up an increasing proportion of UK North Sea reserves and production, this is a serious concern. We therefore highlight downside risks to our long-term reserves and production forecasts, especially if 2012 E&A drilling activity continues to disappoint.

Whilst iron ore and copper import figures are impressive, they do not tell the whole story. Shipping rates to China are subdued, which are a leading indicator for import numbers. For instance capesize shipping rates linked to iron ore shipments have failed to recover following the Chinese New Year, as is traditionally the case. In addition, the year-on-year data shows a significant slowdown in import growth, with iron ore import growth falling every month since August 2011. Copper has proved more resilient with a huge spike at the end of 2011, after copper prices had declined sharply. Looking ahead, we expect copper import demand growth to moderate as prices have now recovered most of their Q311 losses.

We do not expect these record import figures for iron ore and copper to be sustainable, as much of these imports are heading into inventories, pushing the country’s stocks of the metals close to record levels. Therefore, whilst record imports have been recorded it has yet to be matched by similar increases in demand, which would ultimately show the health of metals consumption in the country.

Japan – Current Account (JPYbn)

The January 2012 deficit is the largest recorded in the past 20 years and bodes poorly for the increasingly indebted government and Japanese bond market. As a reflection of the country’s underlying problems of a falling savings rate amid structural population decline, these weaknesses will continue to threaten the government’s financial stability, and we maintain our view that some form of fiscal crisis is highly likely, eventually.

However, while these underlying problems will continue to be a drag on Japan’s growth and external accounts, we believe that investment income flows will continue to stay resilient, and support the yen for the time being. Indeed, the recent deficit barely made a dent in the huge positive net investment position the country has accumulated.

With this in mind, we are very pleased to announce the publication of a new special report, exploring opportunities in global equity markets. The report discusses our strongest macro-industry investment convictions, utilising our unique integration of macroeconomic, financial markets, industry and company analysis to identify where we see the strongest medium- and long-term investment opportunities in equities worldwide.

This approach of looking for the alignment of macroeconomic fundamentals, sector fundamentals, company financials, valuations and technicals enables us to identify investment strategies and drill down to sub-indices or individual equities that give investors exposure to these themes. Furthermore, the analysis of company and industry dynamics gives us greater conviction in our industry and macro views.

The report includes the following information:

• Global Macroeconomic Backdrop
• Key Macro-Industry Strategy Views Update
• Analysis Of Macro-Industry Strategy Investment Themes
• Global Macroeconomic Assumptions
• Global Asset Class Strategy

The report will be available for purchase imminently from Business Monitor’s online store.

This is a false argument. There is indeed a case for US energy independence, but this would not necessarily reduce American involvement (some would say ‘interference’) in the Middle East. For a start, the US is not in the region solely because America needs oil. The US is in the region at least partly because it is expected to guarantee the security of oil shipments (especially through the Strait of Hormuz) to its allies, namely Europe, Japan, South Korea, and a few others. This role augments the United States’ importance in global affairs. If Washington relinquished these perceived responsibilities, then other countries dependent on Middle Eastern oil imports, such as China and India, could be expected to expand their naval capabilities and more actively project their influence in the Middle East. Given that China and India/Japan are already geopolitical competitors in Asia, their rivalry could be carried into the Middle East. Of course, it is highly likely that Beijing and New Delhi (and possibly even Tokyo and Seoul) will seek greater involvement in the Middle East regardless of what the US does, but Washington will not take action to hasten this eventuality.

The second major reason that the US is heavily involved in Middle Eastern affairs is the protection of Israel from external threats. In the past, these have come from Egypt and Syria (until the 1970s), and Iraq (until 2003), and at present, it mainly stems from Iran (and its proxies). If the US were seen to be reducing its commitment to Israel’s security, the Jewish state would become alarmed, potentially prompting it to increase its already powerful military capabilities or even carry out military action against real or imagined threats more frequently.

The third major reason for US involvement in the Middle East is to maintain a balance of power between the region’s most powerful states, namely Iran, Saudi Arabia, Turkey, and Iraq (pre-2003). In fact, the US went to war in the Gulf in 1991 because Iraq, which at the time had the fourth-largest military in the world, invaded a small sovereign state, Kuwait. The US went to war against Iraq again in 2003 on the basis that the latter’s alleged weapons of mass destruction made it a regional threat. Now, there is speculation that the US and/or Israel may attack Iran, because if the latter requires nuclear weapons, it will become the hegemonic power in the region.

Nevertheless, the United States’ involvement in the Middle East has come at a price. Washington’s long-term support for Israel and authoritarian Arab regimes in the region (prior to the Arab Spring of 2011), its deployment of troops in Saudi Arabia in the 1990s and early 2000s, and its repeated military actions against and subsequent occupation of Iraq, have all fuelled anti-Americanism, leading to terrorism in the form of al-Qaeda. Arguably, a powerful new external player such as China could begin with a clean slate and attempt to portray itself as an honest broker. However, if China were to pick sides in the region or pursue hegemonic policies, then it too could generate resentment and ‘anti-Chinese-ism’.

What If The US Abandoned The Middle East?

Let us suppose that the US decided to substantially reduce its commitments to the region. I see several consequences:

• Iran would almost certainly emerge as the major power, even if it did not possess nuclear weapons, for it has a large military and very active external intelligence service. Tehran may be tempted to increase its support for oppressed Shi’as in eastern Saudi Arabia and Bahrain, as well as anti-Israeli groups in the Levant – all of which would prove destabilising.
• Turkey and Saudi Arabia, both Sunni Muslim countries, would emerge as the main competitors to Iran, and I would expect to see a three-way arms race between them. This might also entail a nuclear build up.
• Israel would find itself more isolated in the region, and could become more aggressive as a result. The Jewish state could also be expected to search for a new ‘big brother’, but it is unclear which country can fulfil this role. No major emerging power (eg China) is likely to share America’s knee-jerk commitment to Israel.
• China would almost certainly expand its involvement in the Middle East, and could even establish a military presence in the region. India could be expected to follow suit. Beijing’s choice of partners could radically transform the region’s geopolitics.

Most of the above are already in motion, but these processes would accelerate if the US departed the scene.

Beyond The Middle East

Although much of the discussion of US energy independence has focused on the Middle East, the US has major security commitments in Asia and is in fact stepping up its influence in the region. This is mainly to counterbalance China’s rising power, which is of concern to Japan, the Philippines, Vietnam, and India. Elsewhere, Washington’s commitment to European security is still strong, as evidenced by its plans to develop a missile shield in eastern Europe – at the expense of relations with Russia.

Bottom line: while the US is undoubtedly tired of long wars in Afghanistan and Iraq and would welcome energy independence, it will retain its current security commitments for the foreseeable future.

Political risk premium is justified in the very short term: Amid suggestions that the election was skewed in Putin’s favour, we would caution that a less tolerant response from the authorities (now that the elections are over) may inflame the situation and keep the risk premium for Russian assets (which trade at a discount) elevated for some time to come.

Putin’s team selection will be key focal point: Although Putin confirmed plans to appoint outgoing president Dmitry Medvedev as prime minister, it is unclear how long Medvedev would hold that post. Former finance minister and long-time ally of Putin, Alexei Kudrin, who is highly respected by domestic and foreign investors, has been bandied about as an alternative at some point. New figures could also emerge in time.

The first hints of a more pluralist political system are emerging: Third-ranked presidential contender Mikhail Prokhorov is planning to set up his own party, apparently with Putin’s endorsement. Putin may be seeking to break apart the ruling United Russia party and create a multi-party system, in which several credible pro-Kremlin parties prove sufficient to contain support for the Communist Party, which benefited immensely in last December’s parliamentary vote.

The Communist Party will be the big loser (not winner) from all this: In this context, the days of the Communist Party’s steady second place in elections may be numbered. The emergence of more ‘liberal’ and other alternatives to the Communist Party will redirect votes away from the Communists. An early parliamentary election may be a possibility, once new parties are in place.

The six-year term may lose its appeal to Putin: There is now a growing possibility that Putin will not see out his full six-year term until 2018, or at least be reluctant to run for a fourth term until 2024. There is of course still the risk that he positions himself as de facto president for life. However, this would risk alienating key sections of Russia’s political and economic elite and public in the years ahead. Therefore, Putin may increasingly begin looking for a credible successor over the next few years. With a more pluralist political system likely on the way, a credible successor may become increasingly visible.

The New Zealand dollar against the lira could potentially push much higher from the TRY1.4670/NZD area it has been trading in since mid-2011, if it were to break resistance at around TRY1.4750/NZD. The kiwi dollar also has the advantage of having a bit more carry appeal than the US dollar, for that matter. The Canadian dollar (CAD) and Norwegian krone (NOK), too, look strong against the TRY, and have the additional impetus of being backed by oil exports.

Sterling-Yen And Korean Won Looking Good

At around the JPY121.00/GBP level, we noted that the sterling-yen exchange rate looked ripe for a move in GBP’s favour, and at JPY129.79/GBP now, the cross rate has made a clear break of resistance that sets up significant further gains in the pound’s favour.

Another currency that has broken resistance is the Korean won. The unit is now testing resistance-turned-support at KRW1,116.50/US$. If this holds, on a technical basis at least, it could set up a potential filling of the gap created in September 2011, implying a move to KRW1,080/US$ in the first instance.

Our article outlines the reasons for ongoing mistrust between Russia and the West, identifying both current and historical issues separating the two sides. These include:

• The imbalance of power between Russia and the West since the late 1980s
• The West’s strategic advance into the former Soviet Union and its moves to overthrow Russia’s foreign allies
• Mistrust of Russia among Central and Eastern European states due to the legacy of the Cold War and pre-Cold War antagonisms
• US plans to build a missile defence system in Europe
• Mutual perceptions of hypocrisy
• Long-term historical factors

We argue that despite these issues of contention, Russia’s and the West’s fears of one another are generally exaggerated.

Finally, we also identify factors that could both improve and worsen Russia-West relations over the coming years.

North Korea’s Missile And Nuclear Moratorium

Also on Business Monitor Online, we discuss North Korea’s moratorium on long-range missile and nuclear tests, agreed with the United States on February 29.

This is a positive development, for sure. It reduces the near-term risk of a long-range missile or nuclear test, either of which would be regarded as a provocation by the US, Japan, and South Korea.

As to the reasons for North Korea’s moderation, my colleagues and I believe that the new leader, Kim Jong Un, and his allies are seeking to reduce tensions with the outside world while they consolidate the new regime.

This should also play well in South Korea, boosting the credibility of the South Korean opposition party’s more conciliatory policy towards the North ahead of the South’s parliamentary elections in April 2012. The North wants the Southern opposition to win those elections and the presidency in December, because they are more willing to give aid to the North.

As for Kim Jong Un himself, we expect him to formally assume power in mid-April, which is the centennial of the birth of his grandfather Kim Il Sung (the founder of North Korea), and the date that a conference of the ruling Korean Workers’ Party (KWP) will be held.

Over the longer term, there are grounds to be skeptical about North Korea’s good intentions. Pyongyang can change its tune at any time, and there is no evidence to suggest that it will give up its existing nuclear weapons. In fact, the West’s war on Libya’s Colonel Qadhafi in 2011 will only have increased the importance of owning nuclear weapons in the eyes of the Pyongyang regime.

Exploration is most advanced in Mozambique, where Anadarko Petroleum has put forward an initial commercialisation plan for its five discoveries to date. Anadarko envisages an liquefied natural gas (LNG) export facility with a minimum two-train capacity of 10mn tonnes per annum (tpa), equivalent to exports of approximately 14bn cubic metres (bcm) per annum. KBR is now conducting a pre-FEED (front-end engineering design) study for the prospective facility on behalf of Anadarko. A final investment decision is targeted for end-2013 with first production pencilled in for 2018.

Project costs are expected to hit approximately US$2,800-3,000 per tonne of new capacity, or US$28-30bn. This is in line with similar projects currently under development in Australia, but is still expensive as Tanzania lacks critical infrastructure. Given the price tag, it is likely that Anadarko will team up with Area-4 licence operator Eni in order to spread capital investment costs. If this is the case, a combined LNG facility could be expanded to as many as six trains or 30tpa, equivalent to exports of approximately 41bcm per annum. This could make Mozambique Africa’s second largest gas exporter based on BMI’s 2018 net-export forecasts.

The outlook is also promising for Tanzania’s Rovuma Basin, where Statoil hit gas last week. At present, not enough gas is in place to justify an LNG export terminal, but, with further drilling scheduled for 2012, there is plenty of scope for optimism.

Onshore Outlook

The stand-out onshore prospect in East Africa is Uganda’s Albertine Basin, where UK independent Tullow Oil struck oil in 2006. Tullow estimates that up to 1.1bn barrels (bbl) of probable oil reserves (P50) have already been discovered in the region. With many prospects still to be drilled, Tullow believes the basin could hold an additional 1.4bn bbl of probable reserves.

The development of these Albertine Basin prospects has been delayed because of a protracted dispute between Tullow and the Ugandan government over the terms of a US$2.9bn farm-out deal. Tullow finally received Kampala’s blessing on February 2, 2012, paving the way for up to US$10bn of oil industry investment. The British firm estimates that this investment could see Uganda produce as much as 350,000 barrels per day (b/d) by 2018, more than the estimated 2012 output of the likes of Equatorial Guinea, Gabon, and Congo (Brazzaville).

Tullow’s success is generating further interest in the region, with the Democratic Republic of Congo’s Albertine Basin top of the list. Exploration is also set to kick off this year in Kenya and in Ethiopia’s East African Rift Basin and Tanzania’s Selous Basin. It remains to be seen whether these campaigns will successful, but they are testament to East Africa’s huge resource potential. With oil prices set to hold firmly above US$100/bbl, that interest is only likely to grow.

The major macro themes we see playing out include a mild recession in the eurozone but no break-up, a severe deceleration in Chinese economic activity, and a sustained muddle-through recovery in the US.

Emerging market (EM) economies will continue to be far more dynamic than developed states (with respective aggregate real GDP growth of 4.9% this year versus 1.0%), but performance within EM will be inconsistent, with emerging Europe being the slowest-growing region, and the one with the highest risk profile.

Monetary policy should remain easy and become easier in some cases, with QE3 in the US beginning at some point in the year (most probably June), the European Central Bank (ECB) continuing to support sovereign bond markets, and emerging market (EM) central banks joining the easing party.

In terms of potential risks to our core forecasts, the US economy may prove stronger than we expect, and incoming data suggests that China may be able to forestall a hard landing. The eurozone situation remains hard to call, but we remain relatively optimistic that a long-term, unifying fiscal deal will take shape, although Greece and Portugal at least will have to undergo painful restructuring (debt, economic and otherwise).

For a full overview of our views on global equities, currencies, fixed-income, and oil prices, please visit Business Monitor Online.

Now, however, there is a new hope of sorts. Osaka’s maverick mayor, Toru Hashimoto, is launching a new political movement, including a political training school, which he hopes can radically transform the way Japan is governed. Three of his proposals are very bold to say the least:

Popular election of Prime Minister: At present, Japan’s PM is chosen by the Diet, as is the case in most parliamentary democracies. By making the premier directly elected, the incumbent should a) have greater public support, and b) a minimum fixed-term, meaning that he or she would not have to step down at the first sign of trouble – a fate that usually befalls Japanese leaders. A popular vote for the prime minister could also pave the way for independent or ‘outsider’ candidates less beholden to party or vested interests to rise to high office. Japan’s prefectures already have direct elections for governors, and governors tend to serve many years in office, in stark contrast to the prime minister. Critics fear, however, that this more ‘presidential’ system would allow celebrities to run for office, potentially trivialising politics.

Abolition of the Upper House: One of the reasons why Japan has experienced so much political paralysis (since mid-2007 in particular) is because its two legislative houses have been dominated by opposing forces. In the July 2007 Upper House elections, the then-ruling Liberal Democratic Party lost control of that chamber to the Democratic Party of Japan (DPJ). The DPJ went on to win a huge majority in the more powerful Lower House in the August 2009 general elections, but then lost ground in the July 2010 Upper House vote. The resulting deadlock tends to delay the passage of legislation. Abolishing the second chamber could speed things up, in theory, but it would remove checks and balance considered important in democracies.

Creating super regions: Hashimoto has also spoken of reorganising Japan’s 47 prefectures into eight or nine regional governments that would have considerable autonomy from Tokyo. This would certainly be a dramatic change, for it would allow greater economic competition between the regions, and allow different regional states to experiment with their own policies, without the interference of the central government.

To many in the ruling DPJ and opposition LDP, these proposals are non-starters. At the very least, they would require a change of the constitution, which would in turn need two-thirds support in both houses of the Diet and public approval in a referendum. Yet, it is hard to see the Upper House voting to dissolve itself out of existence. Nevertheless, Hashimoto’s Osaka-based Ishin no Kai party hopes to field 300 candidates and capture 200 seats in the Lower House in the next general election, which must be held by August 2013. This is a tall order, and it is quite possible that his current popularity will have faded by that time. Nonetheless, if Hashimoto and his allies can make headway at the national level, Japan could be due a bigger political shake-up, which could eventually pave the way for real change.

We are watching Hashimoto’s political moves closely, and will be analysing their implications in more detail in Business Monitor Online.

We are in the process of revising our oil forecasts upward, and are even considering the possibility of oil prices breaching their all-time high in the event of a supply shock. As such, we have just published a new article on Business Monitor Online examining the impact of a big increase in oil prices. Higher oil prices run the risk of derailing or at least holding back the US domestic consumption recovery, but there would also be some winners, from oil services companies to oil sector employment. The latter has increased by 51% since 2001, in contrast with non-farm payrolls, which have declined by 0.1% over the same period.

NATO Chief’s ‘No Intervention In Syria’ Comments Could Worsen Conflict

Late last week, NATO Secretary-General Anders Fogh Rasmussen stated that the alliance has no intention of intervening in Syria, even if there was a UN mandate for this. He also rejected the idea of providing logistical support for possible ‘humanitarian corridors’ to Syria’s worst-hit cities. Rasmussen said that Syria is too complicated, ethnically, politically, and religiously, adding that Middle Eastern countries should find a solution to the conflict.

Rasmussen’s comments are risky, because they could actually give Syrian President Bashar al-Assad even greater confidence to crack down on the opposition, which has been in open rebellion for 11 months now. Prior to Rasmussen’s statement, there had been speculation that the Western alliance might launch air attacks in support of the Syrian opposition, as it did in Libya. It could be argued that this ambiguity served as a check on Assad. Paradoxically, Rasmussen’s remarks could make NATO intervention more likely, if Assad now uses even deadlier force, at which point the West would come under rising pressure to intervene.

Data usage has exploded in the past few years and there are no signs so far of a slowdown. In fact, new networks and new devices entering the market will only serve to boost the amount of data we’re talking about – petabytes, exabytes, zettabytes and beyond! This makes data the centre of practically all developments and trends we are likely to see over the next few years. This is both a developed market and emerging market phenomenon.

Chances are, you are reading this on a smartphone or tablet. Data usage over mobile networks continues to grow as handsets become more sophisticated and use more data-heavy applications. In the home, we are already seeing the advent of smart TVs and streaming overtake traditional broadcasting, not to mention the rumblings of smart metering and connected fridges.

Telecoms operators are already struggling to persuade customers to spend more on their data but still need to be able to finance network upgrades that will allow users to keep increasing their data usage. In these tough economic times, it can be difficult to encourage spending. There will be opportunities for network equipment manufacturers to upgrade networks and offer solutions for efficient network management. As networks improve, more services can be offered over the infrastructure by IT companies, new software and service developers, or by the telecoms operators themselves.

As we move to the cloud and storing our data online, new challenges present themselves. Technology often moves too fast for regulation to keep up and data storage does not have to have geographical limitations. Rules and regulations may well inhibit the growth of the cloud industry, even as consumers clamour for more.

When we say ‘hidden risks’, we do not mean ‘black swan’ or completely unpredictable events. Such risks could include a new mass-casualty Islamist terror attack against a major city; a large-scale natural disaster such as a flood or volcanic eruption affecting a key economic region; and the sudden emergence of a new pandemic that disrupts global travel and trade. These are all certainly plausible risks, but they are events whose probability or timing simply cannot be estimated with any degree of confidence. Our list of hidden risks also excludes events such as a geopolitical crisis on the Korean Peninsula or in the South China Sea; a large European state quitting the eurozone; or Western intervention in Syria; because these are all widely recognised, in our view.

Rather, the hidden risks we identify are all developments which, while not necessarily unknown, are sufficiently ‘under the radar’ to most business decision-makers or under-reported by the mainstream media that if they were to escalate, would make investors say ‘I wish I’d known about this earlier’. Our selection of risks was also determined by our belief that each could play out over the next 12-15 months, rather than an indefinite timeframe spanning many years.

For each risk, we identify the warning signals of a potential crisis, the triggers for an escalation, and the key issues at stake for global business.

The key upside level for Brent is US$127.02/bbl, which represents the April 2011 high. A move above this level would be greatly positive for oil prices, with a move to the US$140.00/bbl region last seen in 2008 becoming a real possibility. Technically, any sustained decline would find strong support in the US$105-110/bbl area.

We expect tight supply and ongoing geopolitical threats to help keep oil prices resilient in the coming months. Western consumers would suffer from higher oil prices, but exporters would benefit, with Russian assets, in particular, already looking extremely attractive on both a technical and valuation basis.

We are bullish towards Russian RUB-denominated government bonds and Russian equities, as the RTS index bounced nicely off major support at 1,200 in October. Politics is a risk ahead of the March 4 presidential elections, and the RTS is slightly overbought, but the fundamentals and technicals are aligning nicely for a run to 1,800 and beyond in the coming months (from 1,652 currently).

Japan: Under almost all scenarios we can envisage, Japanese equities look set to outperform government bonds over the medium term, particularly in risk-adjusted terms, with the former extremely cheap from an historical perspective and the latter extremely expensive. Our longer-term outlook for the yen, meanwhile, is bearish, based on the current valuation and what we see as an increasingly accommodative central bank, as highlighted by the recent expansion of its quantitative easing programme. A weaker yen should also support our equities over bonds call.

Latin America: We are amending our Latin American asset class strategy this month, primarily because the appreciatory run in the region’s currencies played out better than we had initially expected. At the start of the year, we named the Mexican peso, Brazilian real and Colombian peso as three currencies we liked most against the US dollar over a medium-term time horizon, and the Argentine peso the currency we liked the least (see our online service, January 5, 2012, ‘Latin America Asset Class Strategy’). Since then our three favourites have outperformed all other regional currencies, while the Argentine peso is the only currency that has weakened against the greenback over the same period.

Given the extreme volatility over the past few days, the Central Bank of Sri Lanka (CBSL) will likely try to keep the rupee at its current levels to foster stability. Indeed, the CBSL managed to keep the rupee fairly stable for close to three months after the first devaluation in November 2011. As we closely watch the rupee’s movements over the coming days, we reiterate that fundamentally, our bias is for continued LKR weakness. Sri Lanka’s balance of payments position remains under pressure from a bleak external demand picture (in particular, Europe’s economic woes), a deteriorating terms of trade (because of subdued cotton prices and the rising cost of oil imports), and insufficient remittance inflows to cushion the blow of a rising trade deficit.

Sri Lanka – Exchange Rate, LKR/US$

As the chart above shows, the latest depreciation of the rupee is comparable to its collapse in late 2008-early 2009, at the height of the global financial crisis. The rupee subsequently recovered from mid-2009 onwards, as ‘Sri Lanka mania’ took hold among some investors following the decisive defeat of the Tamil Tiger rebels, thus ending the three-decade civil war, and paving the way for the island’s reconstruction. But this optimism has now petered out. According to Bloomberg data, Sri Lanka’s rupee is the worst-performing currency in the world thus far in 2012 after the Iranian rial, Gambian dalasi, and Syrian pound. Hardly good company.

Israeli Interests Under Fire

Over the past few days, Israeli diplomatic personnel in Georgia and India have apparently been targeted for assassination, and a man with an Iranian passport in Bangkok injured himself when he accidentally detonated a bomb in his home. In January, an alleged plot to assassinate the Israeli ambassador to Azerbaijan was foiled. There are several question marks surrounding these plots. For a start, Iran might be reluctant to carry out an attack in India, which is friendly with Tehran. In addition, the Bangkok blast has the hallmarks of amateurism, and it would be odd if Iranian agents actually carried real Iranian passports.

Although investigations are still in progress, Israel is bound to see the hand of Iran – either directly, or through proxy groups – behind these plots. For its part, Tehran sees the hand of Israel behind the assassinations of several of its nuclear scientists. With a covert war of assassination seemingly in progress, there is a risk that one side may overplay its hand. This could increase pressure on Israel to attack Iran.

We believe there is no recovery in sight for the sector, because a rise in rates would require both a considerable easing in vessel supply, and a substantial increase in Chinese demand for imports of iron ore and coal. We do not see either development any time soon.

Some ship owners are trying to reduce capacity, as reflected by the fact that a record number of vessels were scrapped last year. However, with fleet growth of about 12% in 2011, even record levels of scrapping were not enough to restore balance to the sector. The effectiveness of scrapping as a means of capacity disposal is further limited by the fact that only vessels over 20 years old are generally sent to scrap yards.

To restore supply-demand balance in the shipping sector, we need to see more vessels laid up (ie mothballed). This is not an ideal scenario for ship owners, as it means the vessels can’t make earnings, and lay-up fees have to be paid. We caution that even if we see an increase in lay ups now, fleet growth of 18% is expected in 2012, meaning the sector is still going to struggle with overcapacity for some time to come.

Our Global Economic Strategists and Head of Europe Country Risk discuss why the ongoing crisis is a domestic balance of payment problem, which needs to be resolved by its own members.

The webinar, which is open to everyone interested, showcases Business Monitor’s:

• Core scenario on the eurozone sovereign debt crisis and the implications for future growth.
• Underlying assumptions for the global economy, the risk of a hard landing scenario in China.
• Views on the implications of a potential meltdown in Europe on global growth.

To request the full presentation please email bmo.global@businessmonitor.com

• The ruling CDU/CSU centre-right party of Chancellor Angela Merkel is doing exceptionally well in national approval ratings, exceeding the roughly 34% it garnered in the last legislative election in 2009.
• A tough stance on Greece, record-low unemployment, and a shift away from local-level issues (which were in the public consciousness earlier last year during state elections) have boosted Merkel’s and the CDU’s standing in public opinion.
• Our call back in mid-2011 that the ascendancy of the Green Party would be short-lived has played out accurately. At the time, we argued that the reason for the ‘Green Revolution’ was record-high business confidence allowing affluent and well-educated Germans to switch their attention towards more domestic issues, such as protecting historical heritage sites and preventing new power lines from sullying the natural landscape. In short, a complete disconnect with economic and political reality in Germany and the wider region. With concerns over the eurozone sovereign debt crisis resurfacing, fears of an imminent default by Greece, and uncertainty over Germany’s own economic outlook, the Greens’ latest poll ratings reflect their traditional core support base.
• The opposition SPD has seen its long-time supporters return after having helped the Greens enter virtually every state parliament in regional elections. However, the SPD is struggling to attack Merkel’s agenda and has toned down its calls for more support for the EFSF and Greece. There is nothing they can do to attack Merkel’s government in its handling of the crisis – unless Germany’s gamble in negotiations with Athens backfires and banks are left with a severe shortage of equity capital in the face of a full hard default by Greece and its departure from the euro.

The Near-Term Outlook

Germany is preparing the domestic political landscape for very controversial moves in the near future. Berlin is under no illusions as to what needs to be accomplished in order to ring-fence other peripheral eurozone states from contagion and set the ball in motion to strengthen fiscal union in the bloc. However, for this the electorate and members of the Bundestag will need to see that Germany has forced the best possible deal out of Athens before releasing further funds. I think it is interesting that even the EC is pretty much echoing all of the reservations expressed by Berlin.

Even if a deal is not struck – which may well be the plan anyway – then Greece will need to be made an ‘example’ of. German banks have had two years to increase their capital buffers and there is good reason to believe that this is exactly what has been happening. Once the Greece issue is out of the way, there will be no doubt about Merkel and company’s firm stance and the release of additional bailout funds for other countries, such as Portugal, will be little more than a formality.

US Dow Jones Industrial Average

Concurrently, the euro has broken above resistance. Back on January 19, we anticipated a rally in the euro to US$1.3250/EUR, stating that “the euro’s move higher [through resistance]… has been accompanied with the Dow Jones breaking through resistance at 12,500… in the short-term at least, the euro and equities may be set to recouple and move higher in lockstep… contrary to a view we have held since October, for divergence between equities and the euro”.

Exchange Rate, US$/EUR

We note that there has been such a recoupling between the euro and US equities, no doubt helped by an unwinding of stretched bearish sentiment on the single currency. Since January 19, the 30-day rolling correlation between the S&P 500 and the US$/EUR exchange rate has risen from –49% to +54%. It appears likely, given the technical moves highlighted above, that a concurrent move higher in both the euro and US equities remains on the cards in the short term – the next level of resistance for the euro comes in at US$1.3650/EUR.

Nevertheless, we remain far from optimistic on the euro’s medium-term trajectory and view short-term strength merely as the preamble to a bearish move. Indeed, we anticipate the ECB’s second Long-Term Financing Operation on February 29, which will dramatically increase the size of the monetary authority’s balance sheet yet again, to see the euro take another leg lower against the US dollar. This should, however, come to the benefit of global equities – resulting in a resumption of the medium-term divergence between the euro and US equities in place since October.

In the first article, we outline our belief that, in anticipation of an investment-led economic slowdown, the Chinese government will increase its efforts to boost the country’s social security net in order to control popular discontent. The political leadership transition later this year will also provide the authorities with an opportunity to enhance their populist credentials. We expect new policies in the healthcare sector, although these are likely to be symbolic given that the government has already adopted a comprehensive healthcare plan. Consequently, any positive developments in the sector will primarily benefit the pharmaceuticals industry (as opposed to medical equipment suppliers and builders of hospitals), especially domestic firms, which we believe are able to provide low-cost pharmaceuticals in line with the government’s affordable universal healthcare coverage aim.

GCC Obesity Levels Increase Risk Of Non-Communicable Disease

In the second article, we outline how diabetes and cardiovascular diseases are the Middle East and North Africa (MENA)’s biggest epidemiological challenge. The underlying cause of these diseases is obesity. The rapid transition to a more urbanised lifestyle with little exercise and poor diets, combined with genetic predisposition and the maintenance of traditional attitudes that do not stigmatise obesity, have caused a huge increase in waistlines and rates of non-communicable diseases. While ‘lifestyle diseases’ are a problem across all emerging markets, as consumer purchasing power increases there is no region that more typifies this problem than the Gulf Cooperation Council (GCC) countries.

The failure of the UN Security Council resolution aimed at ending the Syrian conflict will lead to an escalation of the crisis. Syrian President Bashar al-Assad probably feels safer from the possibility of foreign intervention. Indeed, he may now feel that he has a ‘window of opportunity’ to purge population centres of the rebels, although it is unclear whether he will opt for ‘qualitative’ or ‘quantitative’ escalation.  The former would involve greater use of air power and less restraint, whereas the latter would mean more tanks and troops in action.

The failure of the resolution also makes it less likely that key groups at the centre of power will desert the regime. Potentially rebellious elements of the regime will probably bet that it will survive, at least for now.

The regime’s goals are pretty clear cut. It needs to keep loyalists on side, purge the main towns and cities of rebel activity, maintain control of the Alawite heartland and key roads, and prevent foreign infiltration of its territory.

Despite vetoing the UN resolution, Russia may prod Assad to offer some concessions to the opposition, when Foreign Minister Sergei Lavrov and Foreign Intelligence Chief Mikhail Fradkov visit him on February 7. Russia is not committed to Assad per se, but wishes to retain a friendly regime in Damascus. The trouble is, it cannot force Assad out, and any concessions Assad offers the opposition are unlikely to be sufficient to end the unrest. Moreover, attempts to remove Assad while leaving his regime intact (as happened with Hosni Mubarak in Egypt) are likely to prove extremely difficult, because the Assad family is heavily intertwined with Syria’s security apparatus.

The Arab League (AL) has seen its reputation weakened by the Russo-Chinese veto. Qatar, one of the group’s more active members in the Syrian crisis, is to hand over the rotating AL presidency at the end of March, and there is a risk that new divisions will be evident when the AL holds its annual summit in Baghdad in March.

Going forward, there is a risk that violence in Syria will rise to such high levels that the political pressure for Western countries and their allies to intervene militarily will become irresistible, regardless of the Russo-Chinese veto. However, this would probably be difficult, in view of the political capital (and military resources) used up by the NATO war against Libya. At present, Syria has not featured as a topic in the US 2012 presidential campaign, which is much more focused on the American economy.

Short of direct foreign intervention, external powers have the option of arming the Free Syrian Army (FSA). At present, the FSA is not well organised, and it is under-equipped. Western states, Turkey, and Arab nations all need to decide:

• How best to support the FSA
• What sort of weapons and training should be provided to the FSA
• Whether the FSA should be provided with a safe haven for training, either in Syria or Turkey
• Whether to provide the FSA with a no-fly zone
• How to integrate regime defectors into the FSA
• How to coordinate the FSA’s military activities with the civilian opposition’s political activities

None of the above will be easy. The Arab League lacks the co-ordination to spearhead the FSA. Yet, without professional assistance, the FSA will resemble a rag-tag militia or militias rather than an organised fighting force. Arming and training the FSA will take time. A pure no-fly zone would not prevent Assad’s forces from carrying out a ground assault, while a more aggressive no-fly zone would mean a repeat of the Libya war for Western countries that are already war weary. Meanwhile, integrating regime defectors into the FSA would raise issues such as ranking authority, and leave the FSA open to government infiltration.

The issue of Iranian support for the Assad regime was discussed. Clearly, Iran backs Assad, but has also shown tentative signs of hedging its bets. Iran and Syria have some degree of economic cooperation against sanctions, but Tehran’s tangible support for Damascus appears to be exaggerated. The implications of Syria’s current crisis for Iran are mostly negative. If Assad falls, Iran loses a key ally. If Assad survives, Iran has to contend with a much weaker ally.

The question was asked whether Syria’s merchant and business class in Damascus and Aleppo would abandon support for Assad as a result of the deteriorating economic environment and become a force for change. This may be a stretch, because the business elites are closely associated with Assad’s economic reforms in the late 2000s. They may or may not want Assad out, but they don’t want the opposition in, for fear of retribution against them.

The possibility exists that Assad’s vulnerability is exaggerated, and that he could survive for some years to come, much like Saddam Hussein’s Iraq after the Gulf War of 1991. Although Iraq was trounced in a major international conflict, Saddam crushed rebellions in Iraq’s Kurdish north and Shi’a south and actually strengthened his regime, despite Western no-fly zones and international sanctions. He was only ousted after the US invaded Iraq in 2003.

For further coverage of the Syrian crisis, and Middle Eastern politics, economy, financial markets, and industries, please visit Business Monitor Online.

This latest development strengthens our view that Vicente is the clear frontrunner to take over the presidency (see Business Monitor Online, November 4 2011, ‘Challenges Ahead For Ruling Party Beyond 2012 Election’) at some point during the next presidential term following the September 2012 parliamentary election. BMI believes that the selection of Vicente is a shrewd political manoeuvre, as he already reportedly belongs to the president’s close decision-making circle. This would appear to rule out the prospect of an outright shift in policies and allow for dos Santos, who has been in power since 1979, to continue influencing decisions behind the scenes.

Burma (Myanmar): Political Reform Is Key

We’ve been saying for years that Myanmar has the potential to become a ‘second Thailand’, if only the military-dominated regime would liberalise its political system and reform its economy. During 2011, the new president, Thein Sein, appeared to embark on this path. These are very small steps, but, as the saying goes, ‘every journey has a first step’. US Secretary of State Hillary Clinton’s landmark visit last year has helped spark a sort of Myanmar mania at the present time.

Yoma Strategic Holdings, share price (SGD)

The best example of this has been the trebling in the share price of Singapore-listed Yoma Strategic Holdings – a company which is involved in real estate development, agribusiness, and truck distribution in Myanmar – to a four-year high of SGD0.40 since last December. It’s hard to tell how far Yoma’s share price can keep going, especially after languishing so low for so long. However, broader investor sentiment will remain constrained by Myanmar’s complex multiple exchange rate system, high levels of corruption, and weak infrastructure.

Ultimately, political developments will be crucial. Veteran opposition leader Aung San Suu Kyi is running in by-elections in April, and any further sign of liberalisation thereafter would boost Myanmar’s international reputation and long-term prospects.

Laos: Quietly Humming Along

Laos is arguably the most ‘normal’, politically, of the BLANK states. True, it is a one-party communist state, but it has not shown the level of hostility towards the outside world as Myanmar and North Korea, and it is not at war like Afghanistan. Laos is actually experiencing rapid economic growth, thanks to demand for its natural resources and hydroelectric power. The country inaugurated its stock market in early 2011, which initially surged, but has since fallen sharply (see chart below, click to enlarge).

Laos Stock Exchange Index

Going forward, Laos looks likely to be caught up in a geopolitical struggle between neighbouring China and Vietnam (and possibly Thailand). However, if Laos can skilfully play off its bigger neighbours, it can maximise concessions from Beijing and Hanoi.

Afghanistan: Western Exit To Prove Colossal Challenge

Afghanistan is probably the worst off among the BLANK economies, since it is in the grip of civil war and is in worse shape, physically, than North Korea. Over the last 24 hours, the United States announced that it would seek to wind down combat operations in Afghanistan in 2013, one year before the withdrawal of virtually all Western troops from the country. The news coincided with the leaking of a US military report stating that the Taliban, backed by Pakistan, will retake control of Afghanistan once NATO forces leave. If this prognosis is accurate, and indeed it seems to make sense, then Afghanistan’s economic prospects will remain bleak. Optimists could argue that once the Taliban regains control, the war would be over, and ‘moderates’ could still seek to attract foreign investment, but this is a long shot to say the least.

North Korea: Convergence With South Decades Away, But Upside Potential Is Vast

If Myanmar is potentially a ‘second Thailand’, then surely North Korea is potentially a ‘second South Korea’. There is no reason why the North shouldn’t eventually catch up with the South. The trouble is, this will cost trillions of dollars and probably take decades. This also assumes there won’t be war or state collapse. The death of Kim Jong Il last December at least opens the possibility of change, but so far, the signs are not good. His son and successor Kim Jong Un, although educated in the West, is maintaining the status quo, and even if he were a zealous reformer, he surely lacks the power to enact them. Kim Jong Un’s exiled elder half-brother Kim Jong Nam has been calling for reform, but there’s little he can do from his isolation in Macau.

It’s quite possible that North Korea’s powerful military leaders will eventually promote change, but so far they appear to be years behind their counterparts in Myanmar. Still, if Myanmar’s transition proves successful, it is just about conceivable that generals in Pyongyang will follow suit. According to a Bank of America-Merrill Lynch report cited by the South’s Yonhap News Agency, if the North opens up its economy, it could grow by 10-12% annually. This would make North Korea a significant investment destination.

In Business Monitor Online today, we have published two key articles on Japan and Italy.

In the first, we assess the global impact of a potential Japanese sovereign debt crisis. We outline which countries would be most vulnerable to a withdrawal of Japanese direct and portfolio investment, and the impact on US Treasuries. Although a Japanese blow-up does not appear imminent, we warn that a crisis in confidence, rather than a sudden deterioration in fundamentals, is all that is needed to spark disorder in the bond markets.

Our Italy article is a fully updated version of our long-term political forecast (2012-2021). We discuss the enduring  impact of Italy’s fiscal austerity drive on the country’s political system, social fabric, and regional geography.

More broadly, BMI publishes long-term political forecasts for 100 countries, outlining the main challenges and threats to national stability, and scenarios for how the polity may evolve over the coming decade. These complement our full-range of 10-year economic forecasts for individual states. All are available on Business Monitor Online.

In the case of Croatia, we retain our view that the government will seek IMF backing of some sort this year, which will help avert a full-blown crisis in the economy. This is predicated on the increasingly difficult conditions for Croatian financial markets as a result of tightening liquidity and a persistently weakening macroeconomic backdrop.

The precipitous slide of the kuna against the euro in recent months has prompted the Croatian Central Bank (HNB) to raise reserve requirements (RRs) to 15.0% from 14.0% previously (RRs were last raised by 1 percentage point (pp) in September). The central bank governor, Zeljko Rohatinski, stated that tightening liquidity in the domestic market – which will withdraw an estimated HRK3.1bn from the system – is preferable to running down the country’s foreign exchange reserves as that would be ‘a clear signal to the financial markets that Croatia is facing growing problems with external liquidity’. Full analysis is available in our online service.

Elsewhere, South Korea’s economic growth decelerated for a third successive quarter in Q4 2011. We expect this slowdown to persist in 2012, with net exports acting as the main drag. We anticipate that much of the deterioration in economic activity is likely to come in H1 2012 and we harbour expectations of a modest cyclical recovery in the second half of the year. Consequently, we have revised our 2012 growth forecasts downwards from 2.4% to 1.9%, which still puts us below government projections of 3.7% and a Bloomberg consensus of 2.3%.

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Gingrich’s remarks came in a speech he made while campaigning in Florida, from which the US used to launch the space shuttle, prior to its retirement last year. Gingrich has long had an interest in space exploration, and he emphasised that an enhanced space programme would bring substantial technological benefits. He compared the space programme to efforts to build a transcontinental railway across the US in the 1800s, or the early developments of airlines in the 1930s. He added that it was in America’s interests to acquire so much space experience that China and Russia would never come close to matching it. On this front, Gingrich happily accepted the charge that he was being ‘grandiose’, and that being ‘grandiose’ is ‘American’.

Gingrich’s speech was dramatic, but it is hard to see how an enhanced space programme or lunar base will be a priority for Americans in 2012 or for some time beyond this. Although US economic growth accelerated to an annualised rate of 2.8% in Q4 2011, up from 1.8% in Q3 2011, unemployment remains well above 8%, and the budget deficit and debt burden remain painfully high. It is difficult to see the US channelling substantially more money into the heavens, when there are so many problems on earth.

Nevertheless, Gingrich’s speech raised the possibility of a renewed space race, or more specifically, a race for the moon. At the end of last year, China also announced an ambitious five-year programme for enhanced space exploration that would include more manned spaceflights, and an eventual moon mission. Given that China’s space programme is run by its military – unlike in the US, where there are separate military and civilian space programmes – Washington fears that Beijing could be moving to challenge its dominance in space – something that is crucial for broader US military superiority on earth.

Meanwhile, Russia is not sitting still. Russia, too, announced in January that there should be a permanent moon base – although rather than being a solo effort, the Russian space agency said that it would seek to boost cooperation with the United States’ NASA and the European Space Agency (ESA).

Going forward, it is difficult to tell how much of all this is rhetoric, and how much is sincere. The costs of space exploration are substantial, meaning that the issue will not be a high priority for voters in the US, Europe, and Russia. In addition, China’s economy is at risk of a ‘hard landing’ in 2012 or thereafter, which, if followed by a period of substantially slower growth, could stunt its space ambitions.

Nonetheless, precisely because of its military applications, we would expect the world’s major powers to enhance space capabilities over the coming decade (See our blog post of September 25, 2008, for further background). There is also the prestige factor – which is why India and Japan will maintain space programmes.

However, the fact that Iraq has not been in the headlines belies the very substantial political risks that the country faces in 2012. In an article published on Business Monitor Online on January 26, we discuss the dangers faced by Iraq in the near term:

• Iraq faces rising tensions between the Shi’a majority and the Sunni minority.
• Prime Minister Nouri al-Maliki (a Shi’a) is increasingly seen as an authoritarian figure, raising fears about Iraq’s democratic credentials.
• Iraqi security forces may not be strong enough to prevent a new sectarian conflict.
• A renewed conflict in Iraq would affect the interests of Iran, Saudi Arabia, Turkey, and several other MENA states, and would probably drag them in as proxy players.
• One scenario we outline would be simultaneous civil wars in Iraq and Syria, which would be highly destabilising for the heart of the region, and lead to refugee flows.
• Iraq’s Kurdish region could take advantage of Shi’a-Sunni strains to increase its autonomy from the central government in Baghdad.
• Any protracted political crisis or renewed violence could interfere with the oil sector’s development and deter prospective investors.

The situation is looking precarious. If Syria and Iraq descend into full-blown civil war, and Israel or the US attacks Iran, then the entire region between the Mediterranean and the Afghanistan-Pakistan border will be in conflict. A scary thought.

The key themes for Africa’s oil and gas sector are as follows:

• Total oil production is set to recover quickly in line with Libyan volumes and higher output from Ghana, Angola and Nigeria.
• Gas output is also likely to rise significantly over the next five years to 2016 as new sources emerge and governments attempt to harness previously flared gas for domestic power generation.
• We forecast a rise in oil consumption on the back of steady economic growth. This is likely to necessitate further investment in the downstream sector, with Chinese development loans most likely to be the principal source of investment.
• The main investment opportunities are likely to be upstream, with West African subsalt and East African gas plays among the most exciting projects. High fuel prices are likely to incentivise further exploration and appraisal over the next decade.

We analyse the above issues in more detail in Business Monitor Online.

China: With the economy heading towards a ‘hard landing’, we believe it will become increasingly difficult for the central government to report strong growth figures. While the headline GDP figure is as much a political issue as an economic one, a greater focus on redistribution and rebalancing could be seen as a means to frame weaker overall growth. Consequently, we maintain that China’s economy will grow by less than 8% annually over the coming years. We do caution, however, that there are significant upside risks in the near term, as the forthcoming change in leadership this autumn could compel Beijing to pull out all the stops to prevent growth falling significantly.

North Korea: New leader Kim Jong Un’s exiled elder half-brother Kim Jong Nam has made a number of comments highly critical of the younger Kim and the system over which he presides. In particular, Kim Jong Nam criticised the country’s third dynastic succession, saying that Kim Jong Un is too young and inexperienced to be more than a figurehead, and that the economy needs reform. This has led to speculation that Kim Jong Nam is either positioning himself as a rival to Kim Jong Un, or seeking to force the issue of reform. Nonetheless, there is little that Kim Jong Nam can do from exile, because most of his domestic supporters were ‘purged’ some time ago. It’s possible that China is cultivating Kim Jong Nam as an alternative leader of North Korea, but it is also possible that someone else will emerge, if Kim Jong Un falters.

VIX Index

Equities worldwide have made a strong start to the year. One market that could potentially be nearing an inflection point is China’s. As we previously argued on Business Monitor Online, the Shanghai Composite Index stands to benefit, if we are correct in our expectations of further monetary policy easing by the People’s Bank of China through the coming months as growth cools and inflation moderates further. Downtrend resistance comes in at 2,350.

Shanghai Composite Index

Although the US dollar has strengthened against the euro over the course of the Q4 2011-Q1 2012 rally in global equities, with euro strength still expected to be fleeting in the face of ECB easing, many other currencies appear primed for further upside against the greenback.

One example is the Australian dollar, which remains in a multi-year uptrend and has recently pushed through resistance at US$1.04/AUD. This break points to a retesting of the top end of the Australian dollar’s trend channel – at US$1.20/AUD.

Singapore – Exchange Rate, SGD/US$

The Singapore dollar also looks robust from a technical perspective. After a dramatic sell-off in September 2011, the currency is now rolling over and looks set for a run towards SGD1.2350/US$.

The euro is poised to rally to resistance at US$1.3250/EUR, although we would be cautious at that stage.

Interestingly, the euro has rallied as anticipation has grown surrounding ECB (European Central Bank) and multilateral assistance to embattled sovereign bond markets. This suggests that monetary easing is helping rather than hindering appreciation, as the market is more concerned for now about the structural integrity of the eurozone than about inflation.

The euro’s move higher against the dollar has been accompanied by the Dow Jones breaking through resistance at 12,500. This development suggests that US equities could be set to retest their 2011 highs in the weeks ahead.

Therefore, the euro and equities may be set to recouple and move higher in lockstep in the short run. This would run contrary to a view we have held since October, for divergence between equities and the euro. However, with continued easing by the ECB to be expected, our medium-term conviction remains for divergence, with the euro declining as global equities rally. A break of US$1.3250/EUR would force a reassessment, however.

Main Themes And Trends For Oil Prices In 2012

• Supply-side concerns will continue to provide the main upside risk to oil prices. We expect a supply deficit to ease during the course of the year, but a lack of spare production capacity is likely to make oil markets extremely sensitive to supply-side shocks.
• Saudi Arabia will continue to be the market’s supplier of last resort. Riyadh’s response to Iranian sanctions and the return of Libyan volumes will therefore be critical.
• Stricter sanctions on Iran are set to cause a reorientation in crude flows – a ‘substitution effect’ could push Brent crude higher versus other benchmarks, depending on the severity of an EU ban.
• Demand concerns will provide the main downside risk to prices. Our forecasts indicate robust global demand despite lower growth in China and the eurozone.
• A further downside risk could come from reform to Chinese oil subsidies.

The full article includes our forecasts for oil prices (Brent, Urals, WTI, Opec basket, and Dubai) out to 2016 and is available to subscribers at Business Monitor Online.

• What will be the choices on offer to the Scottish electorate?
• When will the referendum be held?
• Who will vote in the referendum?
• How will the campaign be run?
• What outcome do opinion polls suggest?
• What will be the impact of the referendum on UK politics?
• What would a Yes vote mean for Scotland?
• What would an independent Scotland mean for the UK’s ‘great power’ status?

Overall, with only around 30% of Scots solidly in favour of independence, the referendum will probably fail. Nevertheless, despite the defeat of the Quebec independence referendum in 1980, the separatists regained momentum and came within a whisker of succeeding in the 1995 vote. If the Scottish nationalists lose by a narrow margin, they could eventually try again.

But even if they succeeded, would they really gain ‘independence’? Sovereignty is a hazy concept these days. Several eurozone countries have lost their economic policymaking powers to supranational institutions over the past year. Elsewhere, South Ossetia and Abkhazia seceded from Georgia in 2008, only to become de facto Russian protectorates, which virtually no one recognises. Clearly, Scotland should not be compared to those two statelets, but an independent Scotland would probably join the EU and eurozone (provided the latter still exists!), meaning that considerable political power would be wielded in Brussels and Frankfurt, rather than in Edinburgh.

In many ways, the Republican candidate should be a shoo-in for the White House. Unemployment remains elevated by historical standards, Washington’s fiscal deficit remains eye-popping, and crucially, Obama’s approval ratings are hardly robust (at 46% in the daily Gallup poll, versus 48% disapproving of his performance). Furthermore, the rise of the ‘Tea Party’ movement suggests that the Republican Party base could be re-energised to turn out to vote this year, much as Democrats came out in droves in 2008.

However, we think that Obama should still be considered the favourite to win in November 2012. First, and most importantly, White House incumbents have a natural advantage, so long as the economy is improving by the time the election is held, which we expect to be the case this time around. Second, the Electoral College map is relatively favourable for Obama in our view, with Romney having to make up significant ground in several major swing states such as Ohio and Pennsylvania (we will provide a more thorough analysis as November approaches). As usual, it will come down to a short list of vote-rich states: Colorado, Florida, Iowa, Michigan, Nevada, New Hampshire, North Carolina, Ohio, Pennsylvania, Virginia, and Wisconsin. Given that a majority of these states has traditionally been considered Republican-leaning, and given that Obama has maintained significant support in most, it appears that the Republican candidate will be as much on the defensive as on the offensive. It is very difficult to see a path for a Republican candidate to the presidency without winning North Carolina, for example.

It is certainly unlikely that Obama will win as many electoral votes as he did in 2008 (365 of the 538 available), but it is more likely than not that he will reach the 270 required to win re-election. Of course, this election should be on a knife’s edge, not least because the reallocation of electoral votes as part of the 2010 Census population findings has shifted 14 or more electoral votes to traditionally Republican-leaning states. If Romney can tap into the groundswell of voters who are dissatisfied with the state of the economy, he stands a very reasonable chance of being elected.

In our US 2012 preview article, we also discuss what policies may be expected under a Romney presidency or a re-elected Obama. In a separate article also published on Business Monitor Online today, we also outline Obama’s main foreign policy challenges in 2012.

It was an unlucky Friday the 13^th for France, which lost its AAA credit rating from Standard and Poor’s. Among other things, the downgrade is likely to be prompt a reassessment by investors and the electorate of the Franco-German relationship in ongoing eurozone rescue plans, in which France is increasingly looking less like an equal partner. We cannot rule out the possibility that the change in this dynamic may prompt French President Nicolas Sarkozy to adopt a new tactic in ongoing negotiations, acutely aware that any suggestion of subservience towards Germany is likely to pour salt on France’s wounds, while opening the door for his rival presidential candidates (the election is in April) to manipulate this by adopting a populist strategy. National Front presidential candidate Marine Le Pen has employed this tactic with some success, accusing Sarkozy of selling out to ratings agencies while pushing her neo-mercantile economic policy, which has seen her make gains in the polls. Indeed, we now cannot rule out the possibility that Le Pen makes it through to a second-round runoff election.

That said, the downgrade is not as calamitous as some have posited. Fitch Ratings has affirmed France at AAA for the time being, meaning that technically France maintains AAA-status, although this is unlikely to remain so for long. Secondly, we do not envisage that the additional 100 basis points or so demanded on French sovereign securities will create an unsustainable burden on France’s public financing requirements; they imply an additional cost of US$4bn or so in 2012 – significant, but by no means disastrous.

Far across the world in Taiwan, President Ma Ying-jeou was comfortably re-elected, and his KMT party retained its majority in the legislature. We thus expect to see a continuation of the KMT’s cross-Strait economic integration policies. Indeed, Ma’s election campaign focused on the economic benefits that Taiwan has gained since he assumed office in 2008, touting the Economic Cooperation Framework Agreement (ECFA) signed with China and the resumption of direct air, sea transport, and postal links, as well as the surge in mainland tourist arrivals, as crowning achievements during his tenure.

Ma will now engage in further cross-Strait cooperation, which, in our view suggests brighter growth prospects for Taiwan in the medium term. Beijing has persistently dangled the economic carrot as a means of achieving its final aim of reunification with the island. While such an end-game is unlikely to materialise for a great many years (if ever), we certainly expect a proliferation of deeper integration policies, which should boost businesses on both sides of the Taiwan Strait. China’s share of Taiwan’s exports has surged from just over 2% in 2000 to almost 30% presently, with bilateral trade amounting to approximately US$145bn in 2010. Taiwanese investment in China has totaled almost US$100bn in the last two decades, with almost US$40bn coming during Ma’s first term. Following the conclusion of the ECFA in 2010, free trade negotiations with economies such as Singapore, Indonesia and the EU have either resumed or are likely to commence in the near future.

Similarly, German equities are breaking higher, building on the recovery they have staged since early October. While we anticipate further near-term gains for such assets, we remain very sceptical about the health of the Chinese economy, and we believe a collapsing property market will ensure a ‘hard landing’ in 2012.

Agribusiness Themes For 2012

Earlier this week, BMI’s Commodities Team published its list of agribusiness themes for 2012. In brief, the five themes are:

1. Tightening ethanol supplies
2. Supply shocks due to the La Nina phenomenon
3. Outperformance by food manufacturers’ share prices
4. Risks to commodities trade finance
5. Chinese import fluctuations

We discuss these in greater detail in Business Monitor Online.

There are three channels through which Southern African economies could be hurt, if the region experiences the wrong kind of weather:

Economic Activity: With agriculture making up a sizeable proportion of many Southern African economies, lower harvests would have a detrimental effect on GDP growth. In additon, the number of people who rely on agriculture for income in Southern Africa is disproportionately high when compared to the sector’s overall contribution to GDP. Weaker harvests would therefore have negative ramifications for private consumption. Furthermore, investment would also be impacted by reduced purchasing power and higher borrowing costs as inflation rises and monetary policy is tightened.

Inflation: Food prices make up a large proportion of consumer price baskets in the region. This being the case, food price increases resulting from supply shortfalls could drive inflation higher at a time when almost all Southern African economies are enjoying a period of single-digit price increases. Although high dam levels mean that the risk remains relatively remote at this stage, a prolonged period of poor rains would also hamper hydroelectricity production at the Kariba and Cahora Bassa dams, which would add to inflationary pressures. Located on the Zambezi River, these are important sources of power for Mozambique, South Africa, Zambia and Zimbabwe. Higher inflation in South Africa in particular would be negative for the region, as it would spill into many of its neighbours, given the strong trade linkages.

Monetary Policy: Higher inflation would likely move monetary authorities into tightening mode at a time when domestic and international macroeconomic conditions would otherwise call for loose monetary policy. Indeed, amid growing concerns about the health of the global economy and external demand, the bias in the region is currently to loosen policy in the case of Zambia and Mozambique or maintain interest rates at historically low levels in the case of South Africa.

In our article, we analyse how the above factors will affect the economies of Malawi, Mozambique, South Africa, Zambia, and Zimbabwe.

How Did We Get Here?

Hungary’s economic problems are well documented. Legacies from the previous crisis, namely a large stock of foreign currency-denominated debt and an overleveraged banking sector, have been exacerbated as, respectively, the forint has come under severe pressure and Western parent banks have hinted that they are seeking to limit credit exposure to the weakest economies in CEE.

Compounding matters, Hungary is – by some measures at least – the CEE economy that is the most heavily exposed to trade and investment with the eurozone. This supports our view that Hungary’s economy will be the only one in CEE to contract over the course of 2012.

On the political front, the situation has been no better. The government has been branded as increasingly authoritarian and erratic by both investors and credit rating agencies alike. Legislation to change the nomination structure within the central bank has been likened to a curbing of its independence, while there have also been attempts to diminish the influence of the judiciary and the independent media. As a result, the three major credit rating agencies have dropped Hungary to junk status, and investors have flocked out of all major asset classes.

How Will It All Play Out?  

There is no question that Hungary’s only real escape from its current economic mess rests with a new IMF/EU deal. But there is potential for negotiations to prove volatile and protracted in the meantime, given that Hungary will prove loath to give into external demands. In the meantime, should markets continue to come under duress, we cannot rule out the central bank aggressively hiking interest rates to help stem capital outflows, by as much as 100-200 basis points, as it did back in late 2008.

Ultimately, with the economy heading back into recession, and Fidesz likely to lose face as it is forced to backtrack on major legislative moves, public support should begin to shift away from the centre-right party, potentially yielding a rise in the far-right’s popularity. At the same time though, financial markets could offer attractive entry points as terms of the IMF deal become more concrete. The forint and government bonds in particular look ripe for a bounce.

In a special feature published on Business Monitor Online and in Emerging Markets Monitor this week, we discuss threats to Hormuz shipping. Although my colleagues and I do not believe that Tehran will carry out its threat, we at BMI periodically carry out thought experiments in which negative situations play out. In our special feature, we analyse:

• Reasons why Iran might close the Strait
• The impact this would have on oil markets
• How shipping routes may be disrupted
• The alternative shipping routes from the region
• The reaction of the US and its allies to the closure
• The impact of the closure on the Iranian economy

Even if Iran refrains from closing the Strait, the possibility will keep the oil market on edge. The bigger risk is that a limited skirmish between the Iranian and American militaries at sea could be a prelude to Washington waging a wider war against Iran to neutralise its nuclear programme. This in turn could escalate into a regional conflict, posing yet another danger to a global economy already roiled by the eurozone crisis and the spectre of a ‘hard landing’ in China.

As it happens, a week before Kim Jong Il’s death, I finished reading a book that offers fascinating insights into where North Korea may be heading. The Man With The Baltic Stare is the fourth and latest instalment of the ‘Inspector O’ series of novels featuring the eponymous Korean detective. The books were written by James Church, the pseudonym for a 65-year old former Western intelligence operative with decades of experience in Asia.

The story begins in 2016, with our protagonist being summoned to Pyongyang after having retired from the Ministry of People’s Security in 2011 and having spent the past five years living in seclusion in the mountains. During Inspector O’s five-year absence, Pyongyang has changed dramatically, with new buildings, new lighting, new etiquette, new babies in prams, and the stirrings of an emerging middle class society. Even more surprising for O is that North and South Korea are now cooperating quietly with one another to maintain stability on the Peninsula and have exchanged special liaison officers. O is quickly caught up in the intrigues of South Korean and Chinese agents, who are actively competing against each other to maximise their influence in the North. The South fears that the North could become a de facto Chinese province, while Beijing fears that Seoul is seeking to turn North Korea into a gangster state aimed at causing problems for China.

This web of intrigue soon takes Inspector O to Macau, which has long been a base for North Korean external intelligence and economic activities. There, he investigates the mysterious murder of a prostitute at a luxury hotel, which was apparently committed by the man designated as successor to Kim Jong Il (although neither Kim nor his son are mentioned by name), and who has himself gone missing. Naturally, there are competing foreign interests seeking to discredit or bolster Kim’s chosen successor.

O subsequently journeys to Prague, where some shadowy figures from his previous adventures elaborate on foreign plans for the Korean Peninsula, before sending O back home for a final showdown with his opponents. Who exactly O’s enemies are is often unclear. He does not trust his former employers in the Ministry of People’s Security, but he can hardly trust the South’s ambitious and manipulative point man, Major Kim. Meanwhile, there is more than one Chinese faction at work in this drama. Moreover, although O is a critic of the Pyongyang regime, he is still a patriot, and does not want North Korea to merely become a South Korean or Chinese puppet state.

Inspector O is not a North Korean James Bond. He does not shoot people, jump out of planes or trains, or seduce women. He is 68 years old and does most of his fighting with words. Despite the fact that he is a nuisance to his enemies, none of them make much effort to kill him; instead they are content to manipulate him in their power games. Yet O is surprisingly resilient and has a penchant for witty and acerbic comebacks. Indeed, perhaps because of his advanced age and his lack of family and close friends, O doesn’t seem too concerned about his own fate. This makes it harder for his former employers, and South Korean and Chinese agents, to intimidate him.

Overall, The Man With The Baltic Stare is an unusual spy story with an unusual protagonist living in an unusual country facing an unusual future. This alone makes it an intriguing read.

The Man With The Baltic Stare, by James Church, was published by Minotaur Books in 2010. ISBN 978-0-312-56941-9

Further Reading

Under The Loving Care Of The Fatherly Leader by Bradley K Martin is probably the most comprehensive English-language book ever published on North Korea and the Kim family, although at 800+ pages, it’s one for serious Pyongyang watchers.

Pyongyang: A Journey Into North Korea by Guy Delisle is a highly insightful graphic novel about a Canadian cartoonist’s experiences working in North Korea.

Nothing To Envy: Real Lives In North Korea by Barbara Demick won the BBC Samuel Johnson Prize for Non-Fiction in 2010.

We noted that the definition of ‘hard landing’ varies considerably. Our China analyst provided a qualitative definition, characterised by the following symptoms:

• a sustained contraction in manufacturing PMI (Purchasing Managers’ Index)

• a contraction in services sector PMI
• a sustained fall in imports
• double-digit (%) house price declines
• elevated banking sector stress
• growing expectations of currency weakness

We reiterated that it is very difficult to forecast a hard landing, because aside from the timing issue (for example, it could be 2012, or 2013, or 2014, etc…), there is the data reliability issue. China observers have long questioned the accuracy of official data. In light of this, we essentially have to forecast what we think the Chinese stats bureau will report. Quarterly Chinese GDP data still only reflects year-on-year (y-o-y) changes, and not seasonally adjusted annualised rates. Attempts to calculate the latter from official data series lead to nonsensical numbers.

It was pointed out that investment banks are lowering their China 2012 forecasts, and we are already below consensus. For all we know, actual growth could already be well below official GDP figures.

Beyond 2012, our macroeconomic forecasts for subsequent years, ie 2013-2020, already reflect our expectations of lower growth.

We discussed policy options for the Chinese government, such as interest rate cuts, higher bank lending, and tax cuts, but noted that many options could exacerbate circumstances. Indeed, more lending to state owned enterprises (SOEs) would hurt small and medium sized enterprises (SMEs), in an environment where capital is already drying up. The private sector is at risk.

So how does it all end?

The future of China’s export- and investment-driven growth model is up in the air. It could end with a bang or whimper, and one analyst raised the possibility of a ‘Japan scenario’ of a sharp slowdown, followed by years of lackluster growth.

Another analyst noted that China’s economic liberalisation has slowed, and that the government could become more entrenched in the economy as a result of a hard landing.

We also discussed yuan (CNY) devaluation risks, but felt that depreciation rather than devaluation was more probable. China’s famously humongous foreign currency reserves have already been falling, and there has been capital flight.

Furthermore, we noted that banks could still need a further bailout.

5-10 year view

Much depends on the government’s policy response to a slowdown.

China’s demographic changes alone could trim 1-2 pps off headline growth.

It was noted that despite everything, China’s exports to the US are at an all-time high.

Probable explanations include:

1) China gaining market share from competitors

2) Chinese exports include substantial re-exports

The best-case scenario for 2012-2013 would see a recovery of US growth, and a stabilisation of the eurozone crisis. It involves the continuation of global imbalances and ‘business as usual’.

It was noted that China’s political transition in late 2012-early 2013 means that the government will do everything it can to minimise the risk of macroeconomic instability. Nonetheless, we also acknowledged that policymakers may not be able to prevent a hard landing, despite political pressure.

China is unlikely to see an uprising against the central government unless the economy collapses. There are tens of thousands of incidents of unrest every year, but these tend to be focused on very specific local issues, rather than clamouring for systemic change.

We discussed the international environment. China could become a bigger election issue in the US if American unemployment fails to decline. In Europe, the probable defeat of French President Nicolas Sarkozy in April-May could break the Sarkozy-Merkel axis. Clearly, a further weakening of the eurozone would be bad news for China.

A senior BMI official also noted that there are upside risks to our China outlook, and we need to be cognisant of them.

Over the longer term, even if Chinese growth slows to a much lower average over the coming years, China still offers tremendous potential, in the sense that it’s still a very poor country with room for catch-up with developed states. China is nowhere near as developed as Japan in 1989-1991, when the asset bubble burst. Rather, it is more akin to the US in the 1920s.

Spot Platinum, US$/oz (Monthly Chart

Platinum has failed to break through support-turned-resistance at US$1,450/oz, creating a particularly bearish technical pattern. It has been our view since October 2011 that platinum prices have topped out, and with no significant levels of support until around US$1,000/oz, platinum prices look precarious. Furthermore, as platinum is increasingly being used as an investment tool, we expect significant volatility in the coming months. Platinum ETF holdings have come off the boil in recent months, but remain elevated by historic standards. Additional financial market weakness in the coming months could catalyse a sharp unwind of ETF holdings, which could place significant downward pressure on platinum prices.

Although there is potential for a small short-term bounce for platinum as oversold momentum unwinds, we expect this to be short-lived and unlikely to break through resistance at US$1,450/oz. On the fundamental side, we forecast weak growth in autos demand in Europe, the main component of global platinum consumption. This will weigh on platinum prices and help keep them subdued over 2012.

We expect the spread between gold and platinum ratio to remain positive (in gold’s favour) as gold prices remain elevated due to the metal’s safe haven appeal. The spread is near multi-decade highs and we do not expect it to return to negative territory until a normalisation in global monetary policy causes gold to lose its attraction. As we expect the US Federal Reserve to keep interest rates low until 2014 at the earliest, we anticipate the medium-term uptrend for gold to remain in place.

Palladium looks more attractive than platinum on a technical basis, as the multi-year uptrend remains in place. However, we have stopped short of being outright bullish towards palladium, especially as it has yet to break resistance at US$700/oz. Indeed, we are not yet expecting the ratio between platinum and palladium to resume its multi-year downtrend in palladium’s favour. A key reason for this is that over the long term, our below-consensus view on Chinese economic growth and Chinese autos production in particular do not bode well for palladium. As China accounts for a greater share of palladium demand compared with platinum, it is likely that palladium will be harder hit by a ‘hard landing’ in China.

Global Manufacturing PMIs

The US ISM manufacturing PMI reached 53.9 from 52.7 in November, the highest in six months; Chinese PMI was just above the 50.0 expansionary line following a dip into contractionary territory (though we expect it to falter again); while UK and eurozone PMIs were below 50.0, but came in above analysts’ expectations. Looking at the chart of US manufacturing PMI plotted alongside real GDP growth, we reiterate our general view that the US economic recovery will continue in 2012, though with increasing headwinds from Europe. One of the big risks to this view dissipated somewhat when the US government in December approved an extension of 2011′s payroll tax cuts through February 2012 (a reversion to previous tax rates would have cost the typical household around $1,000 per year).

US Manufacturing PMI And Real GDP Growth

Against this backdrop, the technicals for equities are looking increasingly positive. As the accompanying chart shows, the Dow faces significant resistance at 12,500. A break through this level would offer a further suggestion that the underlying macro fundamentals are continuing to improve as we expect.

Dow Jones Industrial Average

On that note, my colleagues and I recently published ‘Our Key Themes For 2012’, which can be found on Business Monitor Online and in the latest edition of our monthly Global Macro Monitor magazine.

In many ways, our 2012 preview is a continuation of our 2011 outlook. At the end of 2010 we believed the upcoming year would be characterised by heightened political risk, a Chinese economic slowdown, and a culmination of the eurozone crisis. As it turns out, there remains much unfinished business from last year. We expect 2012 to offer answers to some of the really big questions, such as whether the Chinese growth model is doomed, and whether Europe can finally get its act together to save the eurozone. Our macroeconomic growth forecasts are below-consensus, but not dramatically so. However, we are very concerned about the negative tail risks, with a deflationary scenario potentially arising from a combination of deleveraging and a reduction in global demand. No matter how we look at it, 2012 looks set to be at least as interesting – and as challenging – as 2011.

In our 2012 preview, we discuss the following topics:

• Rising global political risk
• China’s hard landing
• The ongoing eurozone crisis
• Gridlock in Washington
• Ongoing global economic imbalances
• Further monetary easing
• Risks of a new European credit crunch

Obama goes to Tehran: Almost everyone (in the risk analysis business) is talking about the prospects of war against Iran in 2012, and certainly the outlook for Western world-Iran relations isn’t particularly good. In light of this, the real surprise would be a major diplomatic breakthrough. What if, somehow, the US and Iran were to reach a ‘Grand Bargain’ over their outstanding disputes, paving the way for President Barack Obama to visit Tehran for handshakes with Mahmoud Ahmadinejad? This would be a truly extraordinary event, greatly reducing tensions in the Persian Gulf and radically transforming regional and potentially global geopolitics.

US third party presidential victory: The US presidential campaign usually begins at least a year before the election, and many pundits believe that it is probably too late for a new candidate to enter the fray. However, even though the weak US economy has hurt Obama’s ratings, the Republicans have failed to find someone with both the credibility and popular appeal to pose a formidable challenge to the incumbent. Against this backdrop, there have been growing calls for a third-party candidate. Recall that Texan billionaire Ross Perot won 19% of the popular vote in 1992, even though he was a late entrant and pulled out of the presidential race during the summer of that year. Perot was able to capitalise on widespread uncertainty at a time when the US was exiting recession and felt outcompeted economically by Japan. It is too difficult to say who would be a third-party candidate in 2012, but the idea merits considerable attention.

China announces democratic transition: The big event to watch in China in 2012 will be the five-yearly Communist Party of China (CPC) congress in the autumn, which will result in the transfer of power to the ‘fifth generation’ of leaders. The congress may also outline some new ideological phrases or mantras for the new era. No surprises there. But what if the CPC does something really surprising, such as outline a timetable for the transition to a fully democratic and competitive political system? Conventional wisdom holds that the CPC will not do this unless faced with ‘Arab Spring’-style unrest. Yet, wiser heads in the party could argue that an elite-led transition would be the best way to head off mass unrest. A democratic China could dramatically change the way the country and economy are run.

Greece-Israel Vs Turkey war in Eastern Mediterranean: Conventional wisdom holds that if Israel gets drawn into a military confrontation in 2012, it would be against Iran, or possibly a more radicalised Egypt. However, Israel’s relationship with Turkey saw noteworthy strains in 2011, and Israel has been quietly boosting military cooperation with Turkey’s arch-rival, Greece. Meanwhile, the Eastern Mediterranean has emerged as a potential flashpoint, due to its gas deposits, the ownership of which is disputed. It’s not inconceivable that Turkey and Israel could come to blows, leading to a limited military confrontation at sea or in the air.

‘Spring’ in the Steppe: The ‘Arab Spring’ of early 2011 put authoritarian leaders around the world on notice that they could be vulnerable to sudden outbursts of people power – four long-time Arab rulers were toppled by the end of the year. Just before Christmas, Kazakhstan saw its worst unrest in the post-Soviet era, when sacked oil workers clashed with police in the west of the country. Kazakhstan has generally been stable since independence, but the political system is completely dominated by President Nursultan Nazarbayev, who has led the country since the late Soviet era. Yet, there has been speculation about his health, and he does not appear to have a clear succession plan. Thus, a key risk is that he could pass away, triggering a destabilising power struggle, whose outcome could lead to mass unrest. And if that were to happen, similar uprisings could take hold in Uzbekistan, Turkmenistan, and Tajikistan (Kyrgyzstan is already democratic), potentially radically transforming the region.

That’s enough to think about for now. I should mention that we also list more ‘mainstream’ ‘wild card’ risks at the end of our latest Global Political Outlook 2012, which was published in Business Monitor Online on December 16, 2011.

On that note, Business Monitor International wishes all its readers a happy new year, free of a ‘hard landing’.

Total Available Credit, % chg y-o-y

Source: BCB, BMI

The main issue with Brazil’s credit boom over recent years has been the nature of bank financing, with loans backed more by debt issuance – much of which has been in the form of external debt – than deposits. This has led to a rapid increase in commercial banks’ loan-to-deposit ratio, one of the highest globally, and has created a system where many lenders, particularly smaller-sized banks, are heavily reliant on expensive, government-backed loans.

Brazil’s monetary authorities had initially stated that they wanted to end this system of state-guaranteed lending in 2012, but concerns about a significant contraction in credit has now prompted them to extend it. In addition the central bank recently announced new regulations to make it easier for larger banks to purchase loan portfolios of their smaller rivals. This should help keep credit flowing for a while longer, and is in line with a period of consolidation in the commercial banking sector in 2012, something Riskwatchdog has expected for some time now. But if the external environment takes another turn for the worse, which is entirely possible given the eurozone’s ongoing sovereign woes, the authorities may struggle to prevent a credit crunch.

Warning Signals

Precisely what would spark a liquidity crisis is not clear, but there are a couple of indicators which would suggest that the banking sector is coming under much greater stress. The most obvious signal would be a surge in non-performing loans (NPLs), something which the central bank is clearly trying to avoid through the recent removal of several so-called ‘macroprudential’ measures – initially implemented to cool credit growth – and the decision to embark on a rate cutting cycle despite inflation being well above target. Although NPLs have been rising in recent months, with the default rate on consumer loans currently standing at 7.3%, compared to 5.7% in December 2010, I believe that the combination of regulatory and monetary policy measures should see this level moderate, if not fall, as we head into 2012.

BRL/US$ Exchange Rate

Source: Bloomberg, BMI

Much more of a risk, in my view, would be an uncontrolled sell-off in the Brazilian real, as this would not only make bank financing more expensive, but it would also hamper consumer spending by significantly raising the cost of imported goods. For this reason I’m watching closely to see whether the real can hold technical support at the key BRL1.9000/US$ level. If we do see the currency sell-off aggressively, the relatively optimistic medium-term outlook for the Brazilian banking sector, and consumer story, could become a lot less favourable.

The MENA region is just beginning its transition to democracy, and the journey could be a long and bumpy one. Meanwhile, Syria is at risk of descending into further chaos, and the risks of an Israeli airstrike against Iran’s nuclear programme are rising. At the same time, relations between Russia and the West look set to cool next year, over a variety of European security issues.

The year 2012 will also see important elections held (in chronological order) in Taiwan, Russia, Iran, France, Mexico, Venezuela, Ukraine, the United States, South Africa, and South Korea, some of which are expected to result in a change of leadership. Furthermore, China will hold its quinquennial Communist Party Congress in the autumn of 2012, during which it will anoint its ‘fifth generation’ leadership.

Amid considerable global uncertainty, one thing is certain: the old saying ‘may you live in interesting times’ is sure to be fulfilled.

Kim Jong Il’s Death: Key Implications

Also in Business Monitor Online today, we discuss the implications of the sudden death of North Korean leader Kim Jong Il. Our Global Political Outlook mentioned this as a possibility in 2012, and back in September, we outlined various succession scenarios. Our broad take is that his son Kim Jong Un can indeed assume the helm, but he will only be a figurehead for a military-dominated collective leadership. Quite simply, Kim Jong Un, aged around 29, has not had the time to be fully trained up to govern the country, and he will need all the help he can get from North Korea’s 60- to 70-something generals and party apparatchiks.

With Kim Jong Il no longer around, there is also a rising risk of a power struggle, which will worry North Korea’s neighbours, for it would raise concerns about who controls the 1.1 million strong Korean People’s Army and all its weapons (including nukes). The new regime’s top priority will be maintaining stability, and thus we expect no major policy changes in the near term. However, we see scope for gradual change over the longer term.

Kim Jong Il was the third major opponent of the West to perish in 2011, after Osama bin Laden in May and Muammar Qadhafi in October. And yet, is the world a safer place? Not necessarily.

This would bode ill for emerging European currencies – the Czech koruna and Polish zloty have already moved sharply lower, but we doubt the sell-off has fully run its course. Of course, Federal Reserve policy is also crucial in determining the dollar’s direction. The Fed has every reason to remain dovish, thanks to low inflation and lingering high unemployment. However, US economic data have been relatively solid through H2 2011, and this may mean further easing is off the agenda for now.

A clear signal that this is the case from the Fed would add to the dollar’s positive momentum, and likely mean that gold will have to hold uptrend support around US$1,550/oz before it can continue its multi-year bull run.

The technical pattern of the Chinese yuan 12-month non-deliverable forward (NDF) outright is extremely bearish. Despite overwhelmingly bullish sentiment towards the currency over the past few years, the 12-month NDF has been unable to appreciate beyond its 2008 high.

While our view of Chinese yuan NDF weakness and our warnings of a potential devaluation may confound those who point out how undervalued the currency is versus the US dollar, we note that on a real effective basis, the Chinese yuan is at its most expensive level since 1994, just prior to the 50% devaluation. The price of a basket of goods in China is still much cheaper than it is in the US, which is why many observers believe the yuan is undervalued. However, according to the IMF (and our projections for 2011), this ‘undervaluation’ is now no longer so large. We estimate the yuan to be just 34% undervalued relative to the greenback, which is the most expensive it has been since 1985, making it less undervalued than the South Korean won or the Taiwan dollar. Considering the much lower GDP per capita is in China, this places the currency well in the expensive category in our valuation model.

Credit Crunch Could Leave Few Options Open

The Chinese property market is in free fall at present, according to anecdotal and private sector sources, and there is a growing risk that the banking sector could experience a widespread credit crunch as the shadow banking system freezes up and non-performing loans soar. Should this highly plausible domestic scenario be combined with a negative shock on the external front (trade flows have thus far held up well in spite of the economic troubles in Europe, but we expect deterioration ahead), then the Chinese government may be compelled to weaken the yuan to help reflate the economy. According to the latest reserves figures, the central bank is acting to prop up the currency in response to capital flight. We see no reason why this capital flight (of both foreign-owned and domestic-owned capital) should not intensify in line with economic weakness.