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10 JUNE 2011

Fixed Income Research

Contributing Strategist

Alastair Newton +44 20 7102 3940 [email protected]

This report can be accessed electronically via: www.nomura.com/research or on Bloomberg (NOMR)

“Issues Which Keep Me Awake At Night”: Mid-Year Review

Key Judgments

MENA: We expect a protracted period of political turmoil and uncertainty across the

region, which will be supportive of the oil price (Issue #1).

Eurozone: Popular and parliamentary unrest related to the eurozone‘s sovereign debt

crisis appears to be on the increase in both core and peripheral Europe, complicating the task of policymakers in calming financial market concerns (Issue #2).

United States: We believe that the debate over raising the debt ceiling is likely to drag

on and that there remains at least a small risk that the 2 August deadline will pass without agreement being reached, triggering a technical default (Issue #3).

Pakistan: Security and the economic situation are continuing to deteriorate as the possibility of a terrorist attack in India emanating from Pakistan persists (Issue #4).

Thailand: The 5 July general election is unlikely, in our view, to sooth domestic

tensions and could trigger renewed serious civil unrest (Issue #5).

North Korea: A recent up-tick in tensions on the Korean peninsula may be the

forerunner of further North Korean ―bad behaviour‖ in the coming weeks and months (Issue #6).

Turkey: The AKP is expected to win a solid majority in the 12 June general election,

but may not win the two-thirds majority which would give it a free rein on constitutional reform (Issue #7).

Taiwan: Polls suggest that the DPP‘s Tsai Ing-wen could pose a serious challenge in

the 14 January 2012 presidential election to Ma Ying-jeou‘s prospects for a second term (Issue #8).

China/US: Since 2008 China has arguably become the world‘s second ―indispensible

power‖, raising some concerns among neighbouring states and in Washington (Issue #9).

Russia: Overseas investors may be over-estimating the importance of continuing

uncertainty over whether Vladimir Putin will stand for re-election as president (Issue #10).

Introduction This report sets out our mid-year review for 2011, updating our 2011 forecast published on 24 November 2010, as well as subject-specific reports published since then. The order of the ten featured ―Issues‖ reflects our subjective judgment of the current importance of each issue to market participants and the number in the brackets in the Issue heading the ranking of each in our original forecast. The final section of the report is an updated calendar of what we see as important ―set piece‖ political events through the remainder of this year and in 2012.

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Nomura | Political Issues Update 10 June 2011

2

1. MENA: Protests, potentates and petroleum (4/8/10)

“Each country is different, while references to a wave of change are simplistic. A range of

political outcomes are likely to be reached, taking divergent paths.”

Richard Haass, Financial Times, 9 March 2011

Our latest assessment of current events in, and prospects for, the Middle East and North

Africa (MENA: A Long and Winding Road, Nomura Fixed Income Research, 27 May 2011)

included the following key judgments:

We believe that the Middle East and North Africa (MENA) appears to be experiencing a “1989 moment”, while judging that transition will likely be uneven and protracted as it

was with the former Soviet empire.

The regimes in Libya, Syria and Yemen are proving tenacious in the face of

intensifying pressure. However, in all three cases determination to bring about regime change does not appear to be waning.

Libya and Yemen aside, with the possible exception of Sudan, we currently see no direct threat to oil/gas output.

However, we acknowledge that potential disruption to output in countries already experiencing protests, and/or in as yet untroubled major oil producers (e.g., Iraq post-

US withdrawal) cannot be ruled out.

We expect events in Egypt to continue to be influential, both indirectly and in terms of

Cairo looking to reassert its standing in the Arab world.

Uncertainties over future developments in Iran, where the regime may be more at risk

from its internal tensions than from popular protests, may act as an additional brake on possible military intervention against Tehran‘s nuclear programme.

We expect Israel to be subjected to increasing international pressure in the coming

weeks to resolve its longstanding stalemate with the Palestinians, but nevertheless remain cautious about prospects for a major breakthrough in the near term.

The death of Osama bin Laden has probably increased the immediate risk of an al Qa’ida-inspired terrorist attack, but may be of little relevance in the longer term.

We see no sign of contagion outside the MENA for now, but do not rule out the

possibility downstream.

We judge the following to be important developments since the publication of our 27 May report (in alphabetical order):

Bahrain: The ―state of national safety‖ ended on 1 June as King Hamad bin Isa al-

Khalifa committed to a national dialogue to be launched in July. However, western journalists report that the atmosphere in Manama remains tense.

OPEC: As had been widely expected, the 8 June OPEC meeting failed to reach

agreement to raise oil production quotas from the level set in December 2008. However, according to the International Energy Agency (IEA), OPEC is already producing 1.3mbpd above the agreed total and some experts believe that Saudi Arabia, concerned over the negative impact of current oil prices on the global economy, may unilaterally boost its production still further above the 8.9mbpd, which the IEA estimated the Kingdom produced in March (the most recent month for which data is currently available).

Tunisia: The interim government has announced that the general election due to be

held in July (for a constituent assembly tasked with writing a new constitution in preparation for presidential and legislative elections) has been postponed for three months after the electoral commission requested more time to prepare for the ballot. It

MENA transition is set to be

protracted and uneven

We expect events in and

around the MENA to remain

supportive of oil prices


3

is possible, in our view, that this may encourage more pressure in Egypt to delay

legislature elections currently due to take place in September.

Yemen: Both the current situation and prospects remain unclear. Following the medical

evacuation of President Ali Abdullah Saleh to Saudi Arabia earlier this month (after he was seriously wounded in what has been reported to have been a rocket attack on the presidential compound in Sana‘a), Yemen‘s ruling party reportedly opened talks with the main opposition coalition aimed at finding a political solution to the stalemate of the past few weeks. However, the authorities have denied that any talks have taken place and continue to claim that Mr Saleh will be back in Sana‘a within the week. Nevertheless, expert opinion is that his absence from the country may offer some sort of opportunity.

We judge that if these events bring Mr Saleh‘s presidency to an end in the foreseeable future this could add momentum to protests elsewhere in the MENA region.

2. European Union: “Summer of discontent – Act 2” update (2) “…we may be witnessing a generational change in European political dynamics. Traditional

left-right divisions have narrowed…. In its place, we are seeing a new division, between globalisers and localisers… [presenting] a challenge to [the] post-war consensus from a new group of revanchists… [which] may spell a new, unprecedented challenge to the European

project.”

Peter Spiegel, Financial Times, 31 May 2011

Our latest full assessment of current events in, and prospects for, the eurozone (EU: “Summer of our discontent” – Act 2, Nomura Fixed Income Research, 31 May 2011)

included the following key judgments:

Popular and parliamentary unrest related to the eurozone‘s sovereign debt crisis

appears to be on the increase in both core and peripheral Europe. Notably: o Germany: Defeat for the ruling CDU/FDP coalition in a recent state election may

owe little to the eurozone crisis, but may still complicate Chancellor Angela Merkel‘s task winning domestic support for additional financial aid for Greece.

o ECB: There appears to be growing cross-party support in Germany (as well as

Finland and the Netherlands) for involving the private sector in any further assistance for Greece, an approach which is opposed by the ECB.

o Greece: Domestic challenges are likely to get even harder, underlining the value of

a possible cross-party consensus on a new package of assistance and of maintaining party discipline in PASOK‘s ranks.

o Portugal: The outcome of the 5 June general election appears to be in the balance,

with markets looking for the emergence of a clear majority government capable of implementing a tough austerity package.

o Spain: With a general election due no later than March 2012, the government is

struggling to meet its deficit reduction target following heavy defeats in May‘s regional elections.

o Belgium: Continuing political paralysis should not unnerve markets unduly unless

the crisis elsewhere in the eurozone deepens significantly.

o Italy: Defeats in May‘s local elections for Prime Minister Silvio Berlusconi‘s had

little, if anything, to do with the eurozone crisis and should not unsettle markets.

o Finland, France, The Netherlands: Right-wing parties in all three countries are

taking electoral advantage of rising euro-scepticism among the electorate and influencing the political weather accordingly.

The ousting of President Saleh

could increase protests across

the region

Popular discontent is

complicating policymakers’

tasks across the eurozone


4

We judge the following to be important developments since the publication of our 31 May report (in our perceived order of importance to financial markets):

Greece: Despite reports over the weekend of 4-5 June that agreement had been

reached between the so-called ―troika‖ (comprising representatives of the ECB, the European Union and the IMF) and the Greek government, it appears that there are still significant hurdles to be overcome before a new ―bail-out‖ package is in place. Notably: o Details of the package have not been revealed, suggesting that agreement has still

to be finalised on at least some elements – see, for example, our comment below on the proposed involvement of private sector creditors;

o On 9 June, the BBC (among others) reported that the Greek Prime Minister, George Papandreou, had won the backing of his cabinet for the package. However, he has still to carry a vote in the parliament, where a reported 30 or so members of his party (PASOK) are threatening to resign rather than support the new package. It appears that the parliamentary vote is now unlikely to take place until after the European Council meeting on 23-24 June and possibly not until early July;

o The main opposition New Democrats in Greece are continuing to resist appeals for a cross-party consensus;

o Strikes and country-wide anti-austerity demonstrations are continuing, raising

concerns, in the press at least, that Mr Papandreou might be tempted to call a snap general election – which opinion polls suggest would result in a hung parliament;

o Differences of opinion appear to be persisting between the German authorities and the ECB over the involvement of private sector creditors in the proposed new package – German finance minister Wolfgang Schauble‘s latest proposal being to replace existing Greek paper with new (interest paying) bonds with a seven-year maturity. Although reports suggest that a majority of holders of Greek government bonds might be prepared voluntarily to roll over the country‘s debt, there is a possibility that the ratings agencies will regard this as a ―ratings event‖ and consequently downgrade Greek sovereign debt to ―D‖ (which the ECB argues it would not then be able to accept as collateral in return for its funding support for the Greek banking sector).

Bank stress tests: There is open disagreement between the German financial markets

regulator, BaFin, and the European Banking Authority (EBA) over some of the parameters which the latter is employing for the second round of European bank stress tests. According to a 7 June report in the Financial Times, the EBA‘s decision to exclude from this year‘s tests certain types of hybrid capital has reportedly forced two “landesbanken to scramble to secure promises from their owners to convert some hybrid capital into better quality equity capital”. Some experts are concerned that the

disagreement could bring the recently established EBA into disrepute, as well as casting a shadow over the stress tests outcome. However, it is, in our view, equally arguable that if the EBA stands firm it will enhance its reputation and ensure that the stress tests are seen as more credible than last year‘s, despite continuing reservations over the non-inclusion of a possible sovereign default as one of the parameters. We note that the EBA has pushed back the proposed date of the announcement of the outcome of the stress tests from June to July, principally to allow time to iron out some issues of data inconsistency among eurozone members.

Portugal: The 5 June general election followed the pattern of recent elections in Ireland

and Spain, as the Portuguese electorate inflicted a heavy defeat on the ruling party (the Socialists). As a result, two right-of-centre parties – the PSD (with 39% of the vote) and the CDS-PP (12%) – will form the next government with at least 130 seats in the 230-seat parliament. In principle, this augers well for the implementation of the austerity programme agreed as part of Portugal‘s EU/IMF bail-out package. However:

o The new government is unlikely to be sworn in much before the end of June which

will leave it little time to implement measures which the EU and IMF have asked to be put in place by early July;

Significant hurdles remain to

be overcome in agreeing a new

bail-out for Greece

The outcome of the second

round of eurozone bank stress

should be released in July

Portugal’s new government

faces major challenges

implementing reforms


5

o Some key measures, eg labour market reform, require changes to Portugal‘s constitution which would need to be approved by a two-thirds majority in parliament, ie requiring the support of at least some members of the Socialists, whom some commentators believe may prove uncooperative following their election defeat; and,

o Public discontent over the prospect of protracted austerity is thought to be running high – exemplified by, for example, a 40% abstention rate in the election – suggesting that the sort of protests which are affecting Spain and Greece may soon be seen on the streets of Portugal too.

Some key upcoming dates for Europe

10 June: Deadline for nominations for the post of IMF Managing Director.

20 June: Meeting of EU Finance Ministers (ECOFIN).

23/24 June: European Union Council of Ministers.

30 June: Final date for payment of the EU/IMF‘s €12bn June tranche to Greece.

July: Outcome of the second round of bank stress tests (date to be announced).

4 Sept: Regional elections in Mecklenburg-Vorpommern.

18 Sept: Regional elections in Berlin.

3. United States: Hitting the ceiling (1)

“…it would be more accurate to say that, rightly or wrongly, markets are more worried about

the US‟s lack of a plan A than Europe‟s lack of a plan B.”

Kenneth Rogoff, Financial Times, 7 June 2011

On 8 June, a senior manager at Fitch warned that the US would probably not be able to maintain its AAA sovereign rating status if it suffered even a technical default on its debt, i.e. if Congress and the Administration fail to reach agreement on raising the debt ceiling before the 2 August deadline expires. However, this does not, in our view, guarantee a rapid resolution. Indeed, we continue to believe that the debate is likely to drag on and that there remains at least a small risk that the deadline will pass without agreement being reached, triggering a technical default, i.e. consistent with Moody‘s 2 June warning of a ―very small but rising risk‖ of default. Moody‘s went on to note that, in the absence of progress with raising the current $14,300bn debt ceiling in the next few weeks, it could put the US rating on review for possible downgrade. In principle, we agree with the publicly stated view of the US Treasury that such warnings from the ratings agencies should help focus policymakers‘ attention on ensuring that agreement on raising the debt ceiling is reached in a timely manner. However, we see little concrete evidence of progress yet, even though party leaders have committed to try to reach agreement within a month and formal negotiations under the chairmanship of Vice President Joe Biden reconvened on 9 June. Recent opinion polls may not help matters. In a Washington Post/ABC News poll published on 9 June, a large majority of those polled conceded that the US economy would probably suffer serious damage if the debt ceiling were not raised. However, 37% of Republicans, 33% of independents and nearly 20% of Democrats said that they were against raising the debt ceiling under any circumstances. Both Democrats and Republicans in Congress are, in our view, likely to be mindful of the fact that the Republicans took more of the blame in the minds of voters when government closed down over budget disagreements in 1995. But this time it appears to us far from clear which party the public would blame more for any failure to reach agreement – which may account in part at least for a deal having been struck over the 2011 budget earlier this year. The Washington Post/ABC News poll suggests that 20% of Americans trust neither party to

We believe that there is some

risk of a technical default over

the US debt ceiling


6

address the country‘s biggest problems; furthermore, although the Democrats enjoy more voter trust overall, the Republicans are ahead of the Administration on the deficit issue and also have the booster of a slim majority calling for debt to be tackled primarily through spending cuts rather than new taxes. We believe that these poll findings may encourage the Tea Party faction in the House in particular to drive a hard bargain within Republican ranks over what compromises their party should be prepared to make to reach agreement over raising the debt ceiling. This stands, in turn, to jeopardise prospects for bipartisan agreement and/or result in an agreement which would still concern markets, e.g. a minimal uplift of the ceiling which would likely require the issue to be revisited before the 2012 elections when electoral politics could make compromise even more elusive.

4. Pakistan: Overshadowed by Osama? (-)

“Since Bin Laden's death, Pakistan has come under increasing US pressure to eliminate militant bases. While some of the militant attacks may have been conducted to avenge Bin

Laden's killing - as some Taliban sources have claimed - others may well be meant to forestall Pakistani plans for an operation in North Waziristan.”

M Ilyas Khan, BBC News, 9 June 2011

At the start of the year we expressed concern over political stability in Pakistan. However, if there has been one piece of potentially good news from Islamabad in recent weeks, it has been the broadening of the ruling coalition, which should help to sustain a greater degree of political stability than we had expected, at least for the immediate future. The first of two steps to this end was the decision in early May of Quaid-i-Azam (the Pakistan Muslim League or PML(Q)) – a party which had supported the previous president, Pervez Musharraf – to join the ruling coalition. This appeared to be the spark for the second, as the Muttahida Qaumi Movement, which had quit the coalition in January, announced shortly after PML(Q)‘s move that it was rejoining. This development has been overshadowed, in our view, by the death on 2 May of Osama bin Laden at the hands of US forces and the various repercussions which have followed, both within Pakistan itself and in Pakistan/US relations. Inside Pakistan, the fragile security situation was highlighted again on 8-9 June when an estimated 100-plus militants stormed a security checkpoint in the northwest of the country as tensions reportedly increase throughout the border region in anticipation of a possible offensive by the army in North Waziristan. This attack followed an assault on the Mehran Naval base in Karachi on 22-23 May, in which one American aircraft was destroyed and another seriously damaged. Meanwhile, the economic situation in Pakistan has given rise to protests in the streets, principally (to date) over seemingly increasingly frequent power cuts and brown-outs. Donor countries, including the US, have identified rehabilitation of the power sector after years of under-investment as a top priority for ensuring political stability. As for Pakistan/US relations, following the death of Osama bin Laden, Pakistan has made a number of overtures to China, interpreted by commentators as an implicit threat to the US.

Most notably, on a visit to Beijing last month Pakistan‘s Prime Minister, Yusuf Raza Gilani, invited China to take over operational control of the Pakistani port of Gwadar. Although we judge that China will likely use the port almost exclusively for commercial purposes, Mr Gilani‘s suggestion that it could be upgraded as a naval base for China has raised concerns not only in Washington, but also in India, where there are already concerns that China

intends encircling it with the so-called ―string of pearls‖ naval bases (see also Issue #9 below). Perhaps inevitably, the recent focus on Pakistan has led to renewed press interest in India/Pakistan relations across what The Economist recently described as “the world‟s most dangerous border”. However, in the editorial focusing on Kashmir which followed, The Economist conceded that: “…while the soldiers growl, the politicians have made progress…and their foreign ministers are due to meet in July”. That said, evidence of genuine progress in Kashmir could, in our view, encourage attempts by Pakistani militants to

Overall, political stability looks

to have improved in Pakistan

recently...

...but the security situation

and the economy are both

very fragile...

...and the risk of a major

terrorist attack in India may be

increasing


7

disrupt bilateral relations through further terrorist acts in India – a risk potentially compounded, as we suggested in our 2011 forecast, by the possibility of the army intervening in North Waziristan.

5. Thailand: Sister act (-)

“The contest between Mr Abhisit and Mrs Yingluck threatens to test the delicate peace that emerged after violent protests rocked Thailand last summer….”

Tim Johnston, Financial Times, 29 May 2011

Thailand is due to hold a general election on 5 July, in which opinion polls are currently suggesting the main opposition Puea Thai party could secure a plurality in the 500-seat parliament, beating the ruling Democrat Party (DP) of Prime Minister Abhisit Vejjajiva into second place by as much as 5 percentage points. As the de facto successor party to Phak Palang Prachachon (PPP), which won the last general election in 2007, Puea Thai is closely associated with former prime minister Thaksin Shinawatra (who was ousted in a coup in 2006 and who remains in exile) – a point that has been highlighted by its choice of Mr Thaksin‘s sister, Yingluck Shinawatra, a leading businesswoman with no previous experience in elected office, as its candidate for prime minister. PPP was dissolved by the courts in late 2008 for alleged electoral misconduct, allowing DP to form a majority government with five smaller parties without going through the formality of a general election. If opinion polls prove to be accurate and Puea Thai does win a plurality there is no guarantee that it would be able to form a majority government – that is to say, the present ruling coalition may still secure more than 50% of the vote and hold together to form a new government. The risk then would be that the United Front for Democracy Against Dictatorship (UDD), often referred to as the ―Red Shirts‖, would reject the election outcome and launch mass protests again, similar to those which led to lethal clashes between the army and UDD protestors in downtown Bangkok between March and May 2010. By contrast, if Puea Thai were able to form a government some commentators believe that the ―Yellow

Shirts‖, or People‘s Action for Democracy (PAD), which has in the past helped to undermine two elected governments, could be re-energised. In short, significant uncertainty surrounds the election outcome and aftermath (with the added possibility of existing tensions erupting into violence in the run-up to polling day), including the possibility of direct intervention of some sort by the military, in our view. Meanwhile, despite the efforts of ASEAN, there has been no progress in resolving the border dispute between Thailand and Cambodia, which has led to several exchanges of fire

already this year.

6. North Korea: The calm before another storm? (6)

“The only predictable thing about the Kim regime is its unpredictability.”

The Economist, 29 May 2010

Despite North Korea‘s repeated offer of talks since the start of the year, relations between North and South Korea remain effectively frozen. Indeed, revelations about recent ―secret‖ talks in Beijing between officials from the two countries may, if anything, have deepened tensions, causing the US to suggest that Pyongyang‘s pronouncements were not “getting us any closer to improving North-South relations”.

1 Furthermore, South Korea is blaming North

Korea for alleged cyber-attacks in March and April. Despite the efforts of China and the US to defuse tensions, we see little prospect of a return to the negotiating table in the near future and remain concerned that domestic economic challenges may encourage North Korea to renew ―bad behaviour‖ in an effort to extort

1 See, eg, ―South Korea acknowledges secret talks with North‖ by Steve Herman, VOANews.com, 2

June 2011.

Opinion polls point to a Puea

Thai plurality emerging from

the 5 July election...

...which may spark a fresh

wave of serious civil unrest

Tensions appear to be rising

again on the Korean peninsula


8

concessions from the international community – perhaps especially as the 100th anniversary

of Kim Il-sung approaches on 15 April 2012, by which date North Korea‘s leaders have repeatedly promised their citizens that theirs will be a ―strong and prosperous country‖.

7. Turkey: The AKP all set for a third term (7)

“…Mr Erdoğan also wants a new constitution to change Turkey‟s system of government, to a presidential system along US lines.”

Delphine Strauss, Financial Times, 7 June 2011

For the past four months or so, with only the odd exception, opinion polls have consistently suggested that the ruling Islamist-liberal Adalet ve Kalkinma Partisi (AKP) should win at least 46% of the vote in the 12 June general election, ie comparable with the 46.66% which the party polled in the 2007 election and which gave it 341 of the national assembly‘s 550 seats. A total of 17 parties will run in the election; but, in addition to the AKP, only two are expected to cross the 10% of the total vote threshold required to win seats:

The centre-left Cumhuriyet Halk Partisi (CHP), under the still relatively new leadership of Kemal Kiliçdaroğlu, is likely to dominate the non-AKP vote with around 25% to 30% of the poll (ie an improvement on its 2007 performance but still well behind AKP);

The nationalist-right Milliyetçi Hareket Partisi (MHP) should just about breach the 10% threshold despite a recent dip in the polls after a series of scandals which the press reports are being unveiled in an attempt to unseat the party‘s leader, Devlet Bahçeli.

2

Meanwhile, the main Kurdish party, Barış ve Demokrasi Partisi (BDP), concerned that it may fail to secure 10% of the total vote, has again opted to run its candidates as independents and will form a parliamentary group if it wins 20 seats (the minimum required), as it did in 2007 and may do so again despite the banning of six of its candidates (together with six others) for having a criminal record. Assuming that the opinion polls are more or less matched by voting on the day, the AKP should win a third consecutive term in government with a healthy majority. However, because of the complexities and uncertainties of the election it is simply not possible to predict with any degree of confidence the likely size of its majority. Nevertheless, the AKP‘s leader (and Turkey‘s current prime minister), Recep Tayyip Erdoğan, has stated that he expects his party to win between 315 and 335 seats. This would give the party an outright majority and sufficient seats (ie 330) to secure parliamentary approval for constitutional changes, which would then have to be put to a referendum; but it would fall short of the two-thirds majority required to amend the constitution without a referendum and which some commentators believe Mr Erdoğan would like to achieve. For Mr Kiliçdaroğlu, in the process of modernising the CHP, a 10pp improvement on the party‘s 2007 performance may be the best which he can realistically hope for, although any significant shortfall on that number could put his leadership at risk, even though he has strengthened his position in recent months. If the CHP can indeed secure around 30% of the total vote, we expect this to provide a sound platform for further modernisation which could equip the party to provide a much tougher challenge to AKP come 2015.

After the election

Assuming the AKP does indeed secure a solid working majority in the 2011 election, we still expect Turkey‘s politics to remain openly fractious for the duration of the new parliament, principally because of continuing tensions between the AKP and the secular nationalists, including the military and the judiciary. This is likely, in our view, to manifest itself in five areas in particular, as follows:

Constitutional reform: Following its victory in the September 2010 constitutional

reform referendum, we expect the AKP shortly after the election to introduce a new

2 See, eg, ―Feeling blue‖, The Economist, 28 May 2011.

AKP should secure a solid

majority in Turkey’s 12 June

general election...

...but a two-thirds majority

looks unlikely

Turkish politics will continue

to be fractious but should not

unsettle markets


9

constitution to replace the current – 1982 – one. The new constitution is likely, in our

view, to be compliant with requirements for EU membership (see below) and will

probably be approved in a plebiscite despite opposition from the secularists;

Cyprus: Although there appear to be little grounds for optimism, efforts are continuing

to resolve the Cyprus question – on which the UN special envoy Alexander Downer told

a conference earlier this year that there had been more progress than is generally

recognised.3 Furthermore, Turkey‘s lead EU negotiator, Egemen Bağiş, recently stated

publicly that, contrary to the views of some commentators, he sees Cyprus‘s six-month

presidency of the EU in the second half of 2012 as an opportunity;

The Kurdish question: We expect the AKP to revive its 2009 initiative to strike a

lasting settlement with Turkey‘s Kurdish minority (ie around 15% of the population),

which ran into the sand as a result of nationalist opposition and the other Kurdish

parties‘ refusal to distance themselves from the Parti Karkerani Kurdistan (PKK);

The presidency: The current president, Abdullah Gul, was elected by parliament in

2007 for a single seven-year term; however, the subsequent introduction of elections by

universal direct suffrage and a maximum of two consecutive five-year terms have made

the timing of the next presidential election uncertain; and,

Ergenekon, An alleged coup plot which has now been formally in the hands of

investigators for four years without (as yet) any convictions, looks set to continue for

months, if not years, yet.

Nevertheless, we doubt that any of these issues is likely unduly to trouble financial markets. As for EU membership, despite the additional barriers which some EU members have been putting in Turkey‘s way since the start of negotiations in 2005, the AKP remains openly determined to press head with reforms consistent with accession, with Mr Bağiş repeatedly stating in public that “the process is more important than the end result”.

4 Certainly as far as

many of the economic reforms inherent in the process are concerned we would not demure with Mr Bağiş‘s view. However, we also recognise that, if achieving the stated goal of the process remains in significant doubt, it is likely to be increasingly difficult to persuade Turks in general and, perhaps, the business community in particular to go along with reforms which will inevitably run against vested interests in Turkey. For more on our assessment of Turkey and its prospects, please see Turkey Anchor Report, Nomura Equity Research, 15 April 2011; and Turkey: The paradox of Turkish elections, Nomura Emerging Market Research, 6 June 2011.

8. Taiwan: A return to cross-strait tensions? (-)

“Ms Tsai's considerable intellectual gifts, her talent for voicing public concerns over environmental and labour issues and her ability to articulate widely held suspicions of China make her a formidable presidential candidate. Yet in order to defeat Mr Ma she will need to

reassure voters that her cross-Strait platform will not result in an increase in bilateral tensions or the undoing of the generally popular liberalisation of Taiwan's trade relationship

with China.”

Economist Intelligence Unit, 20 May 2011

Presidential and parliamentary elections will both be held in Taiwan on 14 January 2011, when President Ma Ying-jeou will stand for a second (and final) four-year term. Mr Ma‘s opponent will be the Democratic Progress Party‘s (DPP) chairwoman, Tsai Ing-wen, who was selected as her party‘s candidate on 27 April.

3 ―Sad island story‖, The Economist, 2 April 2011.

4 See, eg, ―A fading European dream‖ by John Peet at page 10 of The Economist‘s 23 October 2010

special report on Turkey.

Turkey will continue to move

towards EU membership but

progress will likely be slow

The DPP looks set to pose a

real challenge in Taiwan’s 14

January presidential election


10

Although commentators judge that Ma Ying-jeou‘s Kuomintang (KMT) party will retain its majority in the legislature, Ms Tsai is expected to put up a stiff challenge in the presidential race – a view which is supported by early opinion polls. She has already indicated that she will campaign on environmental issues, including scrapping nuclear power generation, which resonate strongly with voters; and that, if elected, she would review the Economic Co-operation Framework Agreement (ECFA) between China and Taiwan. At the same time, expert opinion is that she will need to sooth voter concerns that her election would not increase bilateral tensions. Therein, we believe, lies some risk. In a year which will also see a handover of power in China (see Issue #9 below), the possible election of a DPP president in Taiwan may precipitate an outbreak of nationalist sentiment on the mainland which could trigger cross-strait tensions and, possibly, have a consequent negative impact on China/US relations.

9. China/US: Two “Indispensible Powers” (5)

“The current generation of leaders in Washington and Beijing can probably be relied on to prevent Chinese-American antagonism rising to dangerous levels. It is the next generation

that we should be worrying about.”

Gideon Rachman, Financial Times, 18 January 2011

A new “Indispensible Power”

The phrase ―indispensible power‖ is most closely associated with Madeleine Albright, who first used it publicly to describe the United States shortly after she was sworn in as Secretary of State in December 1996. In May 2009, the then British Foreign Secretary David Miliband opined that “China is to become an indispensible power in this century in the way the US became such in the 20

th century (as described by Madeleine Albright)”.

In our opinion, both the December 2009 Copenhagen climate change summit and the November 2010 G20 summit suggest that international agreement on major issues is already just as dependent on Beijing as it is on Washington. And few would argue that the Sino-US relationship is anything other than the most important bilateral relationship in the world today. So where does that relationship stand after President Hu Jintao‘s January 2011 state visit to the United States? From 4

th to 5

th generation

We continue to believe that in 2011/12 China‘s leaders will be focused increasingly on ensuring a smooth handover of power to the incoming 5

th Generation leadership between

October 2012 and March 2013. Furthermore, in our view, sustaining economic growth (we forecast 9.4% GDP growth this year) is seen by them as an essential context for that process; and a key element in achieving that will be the 12

th Five-Year Plan, which was

finalised at the National People‘s Congress in March 2011. The Plan appears to be consistent with the drive towards more balance between domestic and export-led growth, with market-oriented interest rate reform and with an enhanced market-based managed floating exchange rate regime. We look for further interest rate hikes in 2011 consistent with faster RMB appreciation and with reining in inflation (where food prices remain a particularly sensitive issue). However, we doubt the currency will appreciate quickly enough to satisfy some of China‘s critics in Washington and elsewhere. The currency question: Respite, not resolution

After a succession of draft ―anti-China‖ bills over several years which made little progress in the US Congress, in September 2010 the House of Representatives passed H.R.2378 (aka the ―Ryan Act‖). Had the bill gone on to pass in the Senate and be signed off by the President, it would have obliged the Administration to take account of the alleged undervaluation of the RMB in calculating anti-dumping duties against China. However, the Senate ran out of time, so the bill failed to get as far as the President‘s desk.

China has become the world’s

second “indispensible power”

Beijing is firmly focused on a

smooth transfer of power to

the 5th generation in 2012/13

The issue of China’s

exchange rate is on a back-

burner for now


11

The substantive impact had it been passed into law would not, in our view, have been that significant – the Obama presidency has seen just three cases of additional duties on imports from China (ie tyres, tubular steel pipes and aluminium products). However, similar to the impact of the Administration formally naming China a ―currency manipulator‖, its symbolic significance could have been considerably greater. For all that we do not believe that it would have triggered a trade war per se; rather we think there is likely to have been escalating individual product/sector trade disputes. . With the new Congress in session, on 18 January Senator Charles Schumer and others introduced a fresh bill designed to force the Administration to take a tougher line with China over its exchange rate policy. However, as we judged at the time, some of the heat has gone out of this issue thanks to:

Faster RMB appreciation of 6.2% annualised in nominal terms since mid-2010 (and, as Secretary Geithner has pointed out, 10% plus in real terms);

The passing of the US Mid-Term elections, campaigning for which saw ―China bashing‖ prevalent among members of both parties.

For the time being, therefore, we do not expect to see ―anti-China‖ legislation progressing in Congress; and we expect the US Treasury (as it did at the end of May) to continue to avoid formally naming China as a ―currency manipulator‖ in its half-yearly reports, focusing instead on market access (especially re government procurement) and IPRs. Nevertheless, with the US unemployment rate likely to remain around 9% this year and popular sentiment there weighing against China, the issue is far from dead and could gather new momentum in the run-up to the 2012 elections. A harder edge?

Based on a number of events which have taken place over the past year or so, expert opinion suggests that, although ―soft‖ diplomacy continues to dominate in China‘s external relations, Beijing is far from monolithic in its outlook. Underpinning what some perceive as a harder edge to some aspects of China‘s foreign policy may be a sentiment encapsulated by Philip Stephens in the Financial Times earlier this year, as follows:

“One of the paradoxes of great power status is that it brings its own vulnerabilities. China‟s dependence on foreign raw materials means it has more to lose. This has empowered the PLA. So has rising nationalism transmitted…across thousands of internet sites.”

China‘s leaders would, in our view, ignore popular pressures at their peril – and may have to grapple with rising nationalist sentiment in the coming years. This is arguably consistent with what the Asia Society‘s Orville Schell has described as China‘s desire for “…respect and admission of stature,” and with the view of the Lowy Institute‘s Michael Wesley that China

may, in time, try to push the US away from its maritime borders to enhance its authority over littoral states. “Containment” and the South China Sea

In recent years, China has reached a settlement with neighbouring states on a number of disputed land borders (India being the one outstanding issue). However, Beijing continues to lay claim to what the Economist described as “a great lolling tongue of Chinese sovereignty stuck insolently out at the South-East Asian littoral states” in the South China Sea. Furthermore, China‘s press has described this region as a ―core interest‖ (that is on a par with Tibet), which experts judge to be both strategic and resource-related. In July 2010 US Secretary of State Hillary Clinton, speaking at the ASEAN Regional Forum in Hanoi, called the South China Sea a US ―national interest‖. Her calls for diplomatic solutions to territorial disputes there have been backed up recently with a high-profile US naval presence which has been welcomed by littoral states. Furthermore, in December 2010 Japan – which currently has the second largest blue-water navy in the Pacific – announced

that it would be shifting its military focus away from Russia to strengthen its southern defences. Speaking at a security conference in Singapore earlier this month, US Defence Secretary Robert Gates followed up on Mrs Clinton‘s statement by committing to the US expanding its military presence across the Pacific Rim, deploying new ships and technologies to protect

Nationalist sentiment may

continue to rise in China

Disputes over maritime

borders are persisting...

...as the US commits to boost

its military presence across

the Pacific Rim


12

the sea lanes and strengthening military ties with Australia, Japan, Singapore and South Korea. At the same time Mr Gates reported that the Sino-US military relationship was “on a positive trajectory” following a meeting with China‘s Defence Minister Liang Guanglie, who told the same conference that China remained committed to pursuing a “peaceful rise”.

Figure 1: China/US: Relative Naval Power 2011

Chinese Navy US Navy

Aircraft Carriers 0 11

Cruisers 0 22

Destroyers 28 56

Frigates 52 21

Submarines 65 71

Principal Amphibious Ships 1 31

Command Ships 0 2

Aircraft 290 900

Active Personnel 255,000 335,822

Sources: IISS/US Department of Defense/SIPRI

If any reminder were needed that border disputes in these waters are very much a ―live‖ issue, the flare up in late May and again on 9 June between China and Vietnam, when each

nation accused the other of violating its sovereignty, should have served as one.

Figure 2: Military Expenditure 2010 – Swedish International Peace Research Institute

Country

Spending MER

(US$bn)

Change 2001-

2010 (%)

Share of GDP

(%)

World Share

(%)

Spending PPP

(US$bn)

1 United States 698.0 81.3 4.8 43.0 698.0

2

People's Republic of China* 119.0 189.0 2.1 7.3 210.0

3 United Kingdom 59.6 21.9 2.7 3.7 57.6

4 France 59.3 3.3 2.3 3.6 49.8

5 Russia* 58.7 82.4 4.0 3.6 88.2

6 Japan 54.5 -1.7 1.0 3.3 43.6

7 Kingdom of Saudi Arabia 45.2 63.0 10.4 2.8 64.6

8 Germany* 45.2 -2.7 1.3 2.8 40.0

9 India 41.3 54.3 2.7 2.5 116.0

10 Italy* 37.0 -5.8 1.8 2.3 32.2

11 Brazil 33.5 30.0 1.6 2.1 36.2

12 South Korea 27.6 45.2 2.8 1.7 40.8

13 Australia 24.0 48.9 2.0 1.5 17.3

14 Canada* 22.8 51.8 1.5 1.4 19.4

15 Turkey* 17.5 -12.2 2.4 1.1 23.9

MER = Market Exchange Rate; PPP = Purchasing Power Parity; * SIPRI estimate

That said, and despite the amount of attention which this issue has received in recent months, we think it important to keep China‘s defence spending etc in proportion – see Figures 1 and 2 above. The next 18 months

Referring back to the quote from Gideon Rachman at the start of this section, we readily acknowledge that the leaders of both China and the US are working hard to keep what is, in


13

our view, unquestionably the world‘s most important bilateral relationship on an even keel. However, we do see scope for at least some of Mr Rachman‘s concerns coming to a head before the next generation of leaders is in the driving seat. For, in addition to the handover of power to China‘s 5

th generation leadership, 2012 will see:

North Korea: 100th

anniversary of the birth of Kim Il-sung on 15 April 2012 (see Issue

#6 above);

Taiwan: presidential and legislature elections on 14 January 2012 (see Issue #8 above);

United States: presidential and congressional elections on 6 November 2012.

Individually, let alone collectively, these issues stand, in our view, to encourage leaders to play to domestic audiences at the risk of increased international tensions. Writing in the Financial Times on 18 January 2011, Richard MacGregor described Hu Jintao‘s visit to Washington as “one stop on a much longer journey”. Getting through the potential hazards of 2012 without a significant mishap would mark another important step on that journey. Russia: Will he, won’t he? (-)

“Mr Putin and Mr Medvedev seem to be embracing distinct agendas. Mr Putin is embracing a statist, paternalist, centre-left programme, whereas Mr Medvedev's is a more classically liberal, centre-right programme. The uncertainty is whether these differences are deeply

held, or whether they are for show as the ruling tandem seeks to appeal to the widest possible constituency ahead of the parliamentary election in December.”

Economist Intelligence Unit, 24 May 2011

Commentators continue to debate whether Russia‘s Prime Minister Vladimir Putin will seek a return to the Kremlin in elections due in March 2012 for what would be a six-year term following constitutional amendments (with the possibility of a second six-year term thereafter); or whether he will leave the field clear for the incumbent, Dmitry Medvedev, who appears recently to have been hinting strongly that he would like a second term. Some do not rule out the possibility of the two standing against one another – albeit while questioning the extent to which this would represent a genuine choice for Russia‘s electorate. It is possible, in our view, that Mr Putin will not give a clear indication of his intentions for some time yet – possibly not until after the Duma elections, which will be held on 4 December, for which opinion polls are forecasting a clear (possibly constitutional, ie more than two-thirds of the seats) majority for Mr Putin‘s Yedinaya Rossiya (United Russia) party,

which currently holds 315 of the 450 seats. Our 31 March report Russia: The end of „tandemocracy‟? offered the following scenarios for the 2012 elections, which we stand by for now at least:

Mr Putin runs for president and wins, appointing Mr Medvedev as his prime minister (35% probability);

Mr Medvedev runs for president and wins, appointing Mr Putin as his prime minister (25%);

Mr Putin runs for president and wins, appointing someone else as his prime minister (25%);

Mr Medvedev runs for president and wins, and Mr Putin retires from frontline politics (10%);

An unpredictable event or series of events results in which neither Mr Putin nor Mr Medvedev assume either office (5%).

For more on our assessment of Russia and its prospects please see Russia: Trip notes, Nomura Global economics, 9 June 2011.

“Events” could spark a

deterioration in Sino-US

relations through 2012

We think that Vladimir Putin

will probably be re-elected

president of Russia in 2012


14

Some Important Dates 2011-2012 (Updated 9/6/2011)5 2011 12 June: Turkey – Parliamentary elections 12-13 June: Italy – Referendum on nuclear power 23-24 June: EU – European Council

1 July: EU – Poland assumes EU Council Presidency 5 July: Thailand – Parliamentary elections 16 July: Tibet – Visit of the Dalai Lama to Washington 4 Sept: Germany – Mecklenburg-Vorpommern state elections

18 Sept: Germany – Berlin State elections

24-26 Sept: IMF – Annual Meeting (in Washington)

September: Egypt – Legislature elections 13 September: UN – UN General Assembly sixty-sixth session 23 Oct: Argentina – Presidential and parliamentary elections

23 Oct: Switzerland – Parliamentary elections

31 Oct: Eurozone – J-C Trichet steps down as ECB President October Tunisia – Election for a constitutional assembly

October: Poland – Parliamentary elections

12 Nov: Denmark – Deadline parliamentary elections

26 Nov: New Zealand – Parliamentary elections

November: G20 – Summit (in Cannes, France)

November: G20 – Mexico takes over the G20 Presidency

4 December: Russia – Parliamentary election December: Egypt – Presidential election

2012 1 Jan: EU – Denmark assumes EU Council Presidency

14 January: Taiwan – Presidential and legislature elections 29 March: Iran – Parliamentary elections March: Russia – Presidential election

March: Spain – Deadline for parliamentary elections

15 Apr: North Korea – 100

th anniversary of the birth of Kim Il-sung

5 This list is based on the best information available at the time of going to press and inevitable

changes/firming up of dates will be reflected in future publications. Changes from the previous update are italicised for ease of reference.


15

22 April: France – Presidential election (1

st round)

April: South Korea – Parliamentary elections

6 May: France – Presidential election (2

nd round – if required)

May: Serbia – Parliamentary elections

June: France – Legislature elections

1 July: EU – Cyprus assumes EU Council Presidency

1 July: Mexico – Presidential and congressional elections September: Hong Kong – Legislative Council elections

28 October: Ukraine – Parliamentary elections October: China – Chinese Communist Party 18

th Congress

October: Czech – Parliamentary elections 6 Nov: United States – Presidential and congressional elections

November: G20 – Summit (in Mexico)

December: Kazakhstan – Presidential election

December: South Africa – ANC elective conference

December: South Korea – Presidential election

December: Venezuela – Presidential election

Nomura | Political Issues Update 31 May 2011

16

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