Spex Issue 30

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IN

COLLABORATION

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PROUDLYSUPPORTEDBY

ISSUE 30

7 JANUARY 2013

-SouthKoreaMorethanjustahorsedance?-IstheUSNaturalgasglutsettocontinue?

-Chinasmuchneededeconomicreform

TheFortnightInBrief(24thDecemberto6thJanuary)

US:PartialResolutionoftheFiscalCliff

OnNewYearsDay,theSenatepassedtheAmericanTaxpayerReliefActof

2013,partiallyavoidingtheFiscalCliff.Whilemanyissueshavebeenleft

unaddressed,thebillwillextendtheBush-erataxcutsformostAmericansandsavemillionsfromtheAlternativeMinimumTax.Worldmarkets

reactedfavourablytothepartialdeal,butthedebtceilinginUShasonce

againbeenhitandthebilldoesnotaddressthis.Despitetheuncertainty,

employersadded155,000jobsinDecember,holdingthejoblessrateat

7.8%,almostatthelowestlevelinfouryears.

AsiaPacificex-Japan:RobustdespiteGlobalEconomicUncertainty

TheregionalbenchmarkindexinAsiaposteditsseventhconsecutive

weeklyadvancewithUSbudgetdeal.SurveysofpurchasingmanagersinAsiapointtowardanacceleratingmanufacturingsector.HSBCsPurchasingManagersIndex(PMI)forSouthKorea,TaiwanandIndiarosefrom48.2,47.4and53.7inNovemberto50.1,50.6and54.7respectively.ThedataindicatesthatmanufacturinginAsiaremainrobustdespiteglobaleconomicuncertainty.EU:ThePainofReform

InEurope,MarkitsPMIfortheEurozonewas47.2,aninemonthhighandanimprovementfrom46.5inNovember,despitethefigurebeingindicativeofacontraction.WhileEuropecontinuestofixitsdebtproblems,GermanChancellorAngelaMerkelcautionsthatalthoughreformsarestartingtokickin,economicconditionsarelikelytobemoredifficultin2013.Herwordsarereflectedintheunemploymentrateofalmost12%acrossEurozone,withbudgetcutsandtaxincreaseskeepingspendingandconfidencelow.

SMU Political-EconomicExchange

ANSMUECONOMICSINTELLIGENCECLUBPRODUCTION

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Copyright 2012 SMU Economics Intelligence Club

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SouthKorea:MorethanjustaHorseDanceByAdamTan,SingaporeManagementUniversity

PsysrecentKoreanpopsensationGangnamStyle,whichhasexceededmorethanonebillionviewsonYouTubeontheverydaythattheMayanspredictedastheendoftheworld,isyetanotherfeatthatSouthKoreanscanbeproudof.ThisisasignofhowmuchSouthKorea'sinfluenceintheworldhasgrownsinceitsrecoveryfromtheAsianFinancialCrisisin1997-98.

TheAsianFinancialCrisis,whichhadseenmillionsofcitizensdonatingtheirpersonalgolddowrytothenationaltreasurytoallowthegovernmenttonegotiateaUSD58.4billionbailoutfromIMF1,remainsapainfulchapterinthemindsofSouthKoreans.Sincethen,theSouthKoreanshavenotlookedbackastheirchaebols(SouthKoreanbusinessconglomerates)havegonefromstrengthtostrengthtoemergeasthegloballeadersinmainstreamelectronicsandlifestyleinnovation.ThroughonlySamsung,LGandHyundaigroups,thesechaebolshavebusinessesspanningmultipleindustriessuchaselectronics,insurance,construction,automotiveandevenshipbuilding.Youmustbewonderinghowthishasbeenpossibleinthespanoflessthan15years.ThisistheSouthKoreanmiraclewewillbeexploring.

LeaderinInnovationExportTherewasatimewherethewords"innovation"andhighqualityseemedsynonymouswiththelandoftherisingsun,Japan;andeveryonewantedtoownaJapaneseTV.Timeshavesincechangedasthaterahasmovedpastus.Asmarketsconsolidateandweakerplayersgetweededout,JapansEastAsianneighborhasdonemorethanjustcatchingupandreplicatingJapansinventions.SouthKoreanswentonestepfurthertoimprovetheirinventions.ThisneighborhasbeenoneofthecontributingreasonstowhyJapaneseconsumerelectronicswereunderperformingsincetheturnoflastdecadeandthattrendisexpectedtocontinue.Combiningsleekandergonomicdesignswithcutting-edgetechnology,Samsung&LGhavetakenmainstageintherecentyears.Thissurgeintechnologicalinnovationforsmart

householdappliancesandmobiledevicescoincideswiththerisingpurchasingpowerofthemiddleclassinAsiawhichhasspurreddemandforqualitySouthKoreanexportsglobally.China,forinstance,isoneofthelargestimportersfromSouthKoreaandthetrendisexpectedtocontinue(seeFigure1).

Figure1:KoreasExports(Asia/China)

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WithmajoreconomiesintheworldsuchastheUnitedStatesandEuropeslowlyrecoveringfromtheGreatFinancialCrisis,Iexpectpent-upconsumerdemandfromtheseregionstocontributetoSouthKoreasincreasinglypositivetradebalance2.ThiswillbethepillarofgrowthforthecurrentdecadeforSouthKorea.InvestmentsinGrowthMarketsBesidesbeinggoodatinnovatinganddevelopingcutting-edgetechnology,theabilitytocreatedemandisoneimportantlessontolearnfromSouthKoreans.Withthefinancialcloutgatheredthroughexportingproductsaroundtheworld,SouthKoreastartedinvestinginfrontiereconomies3earlierthanmanyotherdevelopedeconomies.Vietnam,oneofthefastestgrowingfrontiereconomiesinAsia,putsthecaseinpoint.TherelationshipbetweentheseformerbattlefieldenemieshasimprovedasSouthKoreahasplayedakeyroleinVietnamseconomicprogress.ThisallowedSouthKoreacompaniestooutsourceseveralfunctionsforlowercostofproductionandinturn,createdemandfortheirownproductsinVietnamasthemiddleclassmoveupthewealthladder.ThisisjustoneofmanyexampleswithothercountriesinASEANsuchasMyanmarandIndonesiaalsobenefittingfromjointventuresinenergy,electricityandconstructionprojects.WithanincreasingfocusonAsiaasanewenginetodrivegrowth,buildinglongtermsustainablerelationshipsearlywithneighborsisessential

andinthiscase,theSouthKoreanshavedonetherightthing.PossibleHeadwindin2013

TherearetwosidesofacointotheSouthKoreanmiracle.Risingtensionsincetherecentballisticmissiletestbytheirinfamousneighbour,NorthKorea,hasalwaysbeenathornintheirside.DoubtswereraisedbypoliticalanalystsafterNorthKoreanleaderKimJong-UnseemedtosignalthewilltoreducetensionbetweentheNorthandtheSouthinhisrecentNewYearpublicspeech.However,itisbelievedtobelinkedtoafurthercallforaid.Personally,Ibelieveittakesmorethanjustthewillbutalsoasignificantlylongperiodoftimetodissolvethelongstandinganimosity.Newly-electedPresidentParkGeun-Hyehasbigshoesleftbyherfather,formerPresidentParkChung-Hee,tofillastheworldkeeptheireyesonhowshewillattempttoengagetheircounterpart,KimJongUn.ThiscanpossiblyderailtherecentsurgeininvestorsconfidenceinSouthKoreancompaniesaspoliticalriskremainssomethinghardtodiversify.However,apartforthislongtermpoliticalissue,SouthKorearemainsasoneofAsiashopesofdrivingglobalgrowthandiscertainlymorethanjustafamoushorsedance.

Sources:IMF,Worldbank

1Internationalorganisationwhichaimstopromoteglobalmonetaryandexchangerate

stabilitytofacilitategrowthofinternationaltrade.

2Tradeaccountusedtotrackforeigntradevalueinflowsandoutflowsinanations

accounting.

3Subsetofemergingmarketeconomywithlowermarketcapitalizationsandliquiditythatoffersplentyofopportunitiestogeneratehigherexcessreturnsforinvestors.

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Figure2:IncreasingSpreadbetweenNYMEXCrudeOilandNaturalGasPrices

Source:ICIS

Sofar,themainimpactofcheapnaturalgasintheUShasbeenfordomesticelectricity

production.Coalfiredplantsarebeingclosedinfavorofnaturalgasfiredplantsatarapid

rate.From2007to2012,electricitygenerationfromCoalhasdecreasedby25%whileNatural

Gasincreaseditscontributionto35%.

TheFutureofNaturalGasExports

Figure3:December2012SpotPrice($mmBTU)

Source:FederalEnergyRegulatoryCommission

Inthenearterm,thebiggestquestiononeveryonesmindiswhethertheUSwillexport

naturalgas.Asthechartaboveshows,naturalgaspricesinothercountries(especiallyJapan)

areseveraltimeshigherthanintheUS.Japan,whichhasreliedonexpensiveLiquefied

NaturalGasimportsforelectricityproductioninthewakeoftheFukushimanuclearplant

incident,wouldbeaprimecandidateforUSgasexports.

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India China South

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However,evenasdomesticproducersareprimingthemselvestoexportgas,theUS

governmenthasshownreluctancetograntexportpermits1becauseofpoliticalpressuresto

keeppriceslowforconsumers,domesticmanufacturers,andthepetrochemicalindustry.Only

onefirm,CheneireEnergy,hasreceivedapprovaltoexportLiquefiedNaturalGas(2billion

cubicfeet/day)andhasstartedbuildingamulti-billiondollarLiquefiedNaturalGasterminal

inSabinePass,Louisiana.Morethantenotherfirmsarewaitingforthegovernments

approvalandhaveappliedtoexportatotalof27.58billioncubicfeet/daytocountrieswitha

freetradeagreement2,whichismorethanthecurrententireoutputofUSshalegas.

Myviewisthatexportingnaturalgasisnotthesurearbitrage3opportunitythatmanywould

haveyoubelieve.Unlikeexportingoil,therearelargecostsinvolvedinprocessingand

transportingnaturalgas.Liquefaction,shipping,andterminalcostsarelikelytoadd$3.80and

$5.76tothepriceofgasexportedtoEuropeandJapanrespectively.Thismorethandoubles

thepricethatnaturalgastradesatintheUStoday.Furthermore,withnaturalpriceslikelyto

hoveraround$5whenexportterminalsbegintocomeonlinein2015andpriceofWTIcrude

tocomedowntoabout$80(moreinlinewithhistoricalratios),themarginslookincreasingly

small.InEurope,naturalgassuppliedbypipelinesfromRussiawillprovideseriouscompetitiontoAmericanimports.Exportsarestilllikely,particularlytoAsiancountrieslike

Japanwhowillwanttotiedownlong-termcontractsfornaturalgas.

PotentialRustBeltRevival

OneinterestingdevelopmentintheUSisthereturnofrustbeltmanufacturingandindustrial

firms.CompanieslikeShellhavestartedtoexploretheoptionofbuildingmultibilliondollar

chemicalplantswhichusenaturalgasasfeedstocktoproducefertilizersandchemicalsnear

naturalgaswellsinPennsylvania(hometotheMarcellusshalewhichcurrentlyhasthelowest

costofproductionandliquidrichgas).Energyintensiveindustrialactivitieslikealuminum

smeltingarealsooptionsthatcompaniesarehopingtoestablishneargas-producingregions.

Willproductioncontinuetoincrease?

ShalegasishailedinmanyquartersasthekeytoAmericanenergyindependenceandagame

changerfortheUSeconomy.Afterall,thegrowthinnaturalgasproductionoverthelastfew

yearshasheavilyreliedonshalerockplays,whichcurrentlyrepresentapproximately30%of

allgasproduction.However,evenaslargeinvestmentsweremadein2012foreignoilmajors

likeFrancesTotalandNorwaysStatoilinUSShale-rockformations,shalegasproduction

begantoplateauinearly2012,andtherearesignsthatitspotentialmaybeoverstated.

Stagnatingproductionlevelsaremostlyduetorecordlowgasprices.At$3,itisunprofitable

toextractnaturalgasfromalmosteveryknowngasfield.Manyshalegasoperatorsare

drillingatbelowthe$5to$6necessarytobreak-even(costsalsoincludeleasing,exploration,

anddevelopment).Furthermore,simplykeepingoutputconstantrequiresconstant

explorationandproductionbecausewelloutputdecreasesbyabout50%afteroneyear.

Atthesametime,overstatedshalegaswellproductivitycastsdoubtuponclaimsthatthereis

aproven100yearsupplyofnaturalgasintheUS.Thefirstproblemisthatshalegas

extractionisrelativelynewandtherearefewcrediblemodelsaboutextractionvolumesinthe

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longrun.Producersoftenreportinitialextractionflowratesinsteadofaverageones,or

estimatelongerlifespansforwellsthanislikely.Furthermore,USEnergyInformation

Administrationdatashowsthatthereisonly11yearsworth(atcurrentconsumption)ofgas

inprovenreserves.Therestofitisfromprobable,possible,andspeculativeresources.

Sources:ConsumerEnergySolutions,Factset,FederalEnergyRegulatoryCommission,ICIS,

Forbes,PFCenergy,WSJAnalysis

1Alegaldocumentthatisnecessaryfortheexportofgoodscontrolledbythegovernment.

2Atreatybetweentwoormorecountriestoestablishafreetradeareawherecommerceingoodsandservicescanbeconductedacrosstheircommonborders,withouttariffsorhindrances.

3Takingadvantageofapricedifferencebetweentwoormoremarkets.

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ChinasmuchneededeconomicreformByWongShou,SingaporeManagementUniversityFinally,theglobaleconomiccrisishastakenatollonAsiasbiggesteconomy.Theongoing

EuropedebtcrisisandtheweakeningAmericaneconomyhavehamperedChinasexport

market,contributingtoitsdecreasingGDPgrowthratesover7consecutivequarters.Chinas

decliningperformance(9.8%y/yincreaseinGDPin1Q11to7.4%in3Q12),alongwithitsvulnerabilitytowardsexternalshockshassetalarmbellsringing.Tobettershelterthe

countryfromtheoverseasbrewingstorms,Chinarecognizesthatitneedstorebalanceits

economicstructure.Thisreformwillseeitseconomyshiftfromonethatreliesheavilyon

investmentandexports,toonethatsdrivenlargelybydomesticconsumers-anditsnew

leadershavetoactfast.

Figure1:ChinasActivitiesasaPercentageofGDP

Source:CEIC

Domesticconsumptionhasbeenonadowntrend,andin2011,itaccountsforonlyamere

34%ofChinasGDP.Chinaslowconsumptionandhighlevelofinvestmentshighlightthe

internalimbalancethatiscurrentlyplaguingthecountry.TheChineseleadershavelong

acknowledgedthisfundamentalproblemanddiscussionshavetakenplacewithinthepartyto

implementpoliciestodevelopamoremarket-orientedeconomy.Thisis,however,abig

challengeforthecountry,aswehaveseensomeresistancefrompoliticalfiguresandbusiness

elitestopreventlosingthecurrentmodelthathasbenefitedthemwellovertheyears.

OverinvestmentinGrossCapitalFormationinChina

At48%,ChinasinvestmentasapercentageofitsGDPisexceptionallyhighrelativetoboth

thedevelopingBRICcountriesandleadingdevelopednations.Thetwomainfactorsbehindits

highlevelofgrosscapitalformationinChinacanbeattributedtotheroleofstate-owned

enterprises1(SOEs),aswellasitsover-relianceoninfrastructureinvestment.

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2001 2003 2005 2007 2009 2011

Investment Consumption Net Exports

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Figure2:GrossCapitalFormationasapercentageofGDPbycountries(2011)

Source:Worldbank

RoleofSOEsinChina

Chinaisknowntobeagovernmentledeconomy,whereafewpowerfulSOEsdominatein

theirrespectivesectors.AccordingtoNomuraBank,theseSOEsemployabout21%ofthe

workforce,produced27%ofindustrialoutput,andcontrolamassive44%ofcapitalstocks,

despiteaccountingforonly4.7%ofthetotalnumberoffirmsinthecountry.Notonlydothey

receivehugesubsidiesfromthegovernments,thefinancialsystemalsoprovidesthemwith

preferentialcreditterms,givingthemaccesstocheapcapitaltofueltheirinsatiableappetite

forcapitalinvestments.TheauthorityandpoweroftheseSOEshavetobescaleddown,and

suggestionshavebeenmadetoincreasetherequireddividendpayoutsfromthesecompanies.

Thisis,however,easiersaidthandonegiventhatthepastdecadesofcapitalcronyism2and

nepotismhavecomplicatedtherelationshipbetweenthegovernmentandSOEs.Whether

Chinacansuccessfullyoverhaulthisinefficientmodelultimatelydependsonthepolitical

stomachofitsnewgenerationofleaders,andmanyobserverswillbemonitoringthe

leadershipofXiJinpingintheupcomingyears.

Over-relianceonInfrastructureInvestment

Asaresponsetotheglobaleconomiccrisisin2008,thegovernmentimplementedaRMB4

trillion(USD586billion)stimuluspackage,ofwhich38%ofitwenttopublicinfrastructureinvestment.Furtherexacerbatingtheimbalanceisthefactthatthebigcommodities,

transportationandconstructioncompanieswhobenefitedfromthisstimulusaremostly

SOEs.InSep12,withtheoutlooklookinggrimmerandtheimminentriskofahardlanding,

theChinesegovernmentannouncedanadditionalRMB1trillion(USD160billion)worthof

infrastructureinvestments.DespiteChinashighrelianceoninvestments,capitalformation

willbelikelytocontinueitsgrowthasthecountryacceleratesitsinfrastructureprojectsto

supportitrapidurbanizationprocess.Further,withglobaleconomicconditionsunlikelyto

improvein2013,Chinaisexpectedtocontinueitsinfrastructureinvestmentasameanto

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China Russia India Brazil Germany Japan UnitedKingdom

United States WorldAverage

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driveitseconomy.Unfortunately,itseemslikeChinasrebalancingprioritieswillbetakinga

backseatyetagain.

Consumptionasamainsourceofdriver

Figure3:ConsumptionasaPercentageofGDPbyCountries(2011)

Source:Worldbankdata

Withthelargestpopulationintheworld,itshardtofathomhow1.3billionpeopleconsume

only34%ofthecountrysGDP.Partofthereasonisduetothecountrysill-equippedsocial

welfaresystemthathasforcedhouseholdstoincreasetheirprecautionarysavingsforfuture

expenditure.Ontopofthat,Chinasimmaturefinancialsystemprovidesonlystingyreturnson

investments,anditsxenophobicpolicieshavelimitedcompetitionwithintheeconomyanda

misallocationofresourcesskewedhighlytowardslocalfirms.Allthesefactorshaveplayeda

partinincreasingdomesticsavingsaswellassuppressingthepotentialgrowthofhousehold

disposableincome-thetwomainreasonsbehindthecountrysdecliningconsumption.

Fortunately,therequiredreformstoempowertheChinesehouseholdsfacefewerheadwinds,

andthegovernmenthasbeenactivelyunravelingplanstoliberalizethefinancialsystem,

increaseforeigninvolvementintheprivatesector,andrestructurethesocialsystem.For

instance,ChinahaspledgedtoallowforeignfirmstoincreasetheirstakeinChinesefinancial

servicefirmsfrom33%to49%tointroducemorecompetitioninthesecuritiessector.Other

policiesthatareinthepipelineincludeanapprovaltoincreaseminimumwageatanannualgrowthrateof13%until2015.Suchinitiativeswillcertainlyseedomesticconsumers

benefitingfromamorecompetitiveandmarket-orientedeconomy,wherehigherdisposable

incomeandalowerpropensitytosavewilltranslateintohigherconsumption.

Challengesandoutlook

Atatimewheretheneedforeconomicreformisevermoresoimportant,Chinastillfacestwo

inherentchallengesinthisendeavor.First,thepoliticalreluctanceanddifficultiesthatofficials

faceintheirattempttorestructuretheSOEsandredefinetheirroles.Second,theincreasing

infrastructureinvestmentamidstthebleakeconomicconditionsandrapidurbanization

process.Itislikelythatinvestmentspendingwillcontinuetoremainhighintheshorttermas

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Chinacontinuestofenditselfagainsttheadversityoftheglobaleconomiccrisis.Aslongas

investmentsdonottaperoff,thegoalofachievingaconsumptiondriveneconomyremains

quiteadistanceawayevenifconsumersareincreasingtheirspending.Ultimately,consensus

amongtheChineseleaderswilldeterminetheoveralldirectiontheeconomyisheading

towards.Withanewleaderatthehelmoftheparty,politicalobserversareconfidentthatXi

Jinpingwillembarkonthiseconomicoverhaulsomethinghispredecessorhasfailedto

accomplish.However,thenewreignhasonlyjustbegun,andstrongerandmorepositivesigns

havetobewitnessedbeforetheeconomicintentionsofthenewgenerationofleaderscanbe

ascertained.

Sources:WallStreetJournal,NewYorkTimes,China2030WorldBankReport

1Alegalentitythatiscreatedbythegovernmentinordertopartakeincommercialactivitiesonthegovernment'sbehalf.

2Aneconomyinwhichsuccessinbusinessdependsoncloserelationshipsbetweenbusinesspeopleandgovernmentofficials.Itmaybeexhibitedbyfavoritisminthedistributionoflegalpermits,governmentgrants,specialtaxbreaks,orotherformsofdirigisme.

3China'srapideconomicgrowthinrecentyearshasoftengivenrisetospeculationaboutthepossibilityofahardlanding,inwhichtheeconomyslowsdownfromadouble-digitratetoagrowthpaceinthelowsingledigits.ThiscouldoccurifmeasuresbytheChinesegovernmenttotightenmonetarypolicyslowdowngrowthfasterthanitexpects,orwouldlike.

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TheS&P500isafree-floatcapitalization-weightedindexpublishedsince1957ofthepricesof500large-capcommonstocksactivelytradedin

theUnitedStates.IthasbeenwidelyregardedasagaugeforthelargecapUSequitiesmarket

TheMSCI Asiaex JapanIndex is a freefloat-adjustedmarket capitalization indexconsisting of10developedand emergingmarket country

indices:China,HongKong,India,Indonesia,Korea,Malaysia,Philippines,Singapore,Taiwan,andThailand.

The STOXXEurope 600 Index is regardedasa benchmark for European equity markets. It represents large, mid and small capitalization

companiesacross18 countriesof theEuropean region:Austria,Belgium,Denmark, Finland,France,Germany,Greece,Iceland,Ireland,Italy,

Luxembourg,theNetherlands,Norway,Portugal,Spain,Sweden,SwitzerlandandtheUnitedKingdom.

Correspondents

VeraSoh(VicePresident,Publication)Vera.soh.2011@economics.smu.edu.sgSingaporeManagementUniversitySingapore

JiaWeiNg(VicePresident,Operations) [email protected] SingaporeManagementUniversitySingapore

SamuelOng(PublicationsDirector/Editor)[email protected]

Singapore

ShreyaChatterjee(MarketingDirector)[email protected]

Singapore

YingyuZeng(LiaisonOfficer)Yingyu.zheng.2010@economics.smu.edu.sgSingaporeManagementUniversitySingapore

DarrenGohXianYong(Editor)Darren.goh.2010@business.smu.edu.sgSingaporeManagementUniversitySingapore

AdamTanKianHungadam.tan.2009@business.smu.edu.sgSingaporeManagementUniversity

Singapore

WongShouYeesywong.2010@business.smu.edu.sgSingaporeManagementUniversitySingapore

[email protected]

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