SPEX Issue 5

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ISSUE 5 7 NOVEMBER 2011

- The Price of the Safe Haven (Part II) - Understanding the BRICs (Part II) - Deflation in Japan - Gadaffi’s Death – Libya’s Black Gold May Do Little for Oil Prices The Fortnight In Brief ( 24 October to 4 November ) Global markets surged in the first half of the fortnight, on euphoria regarding European leaders’ reaching an agreement to contain the region’s crisis, before sliding again after. Additionally, of particular interest were MF Global’s bankruptcy, and hints of future action from the Fed. US: Plenty of drama US markets saw their best month in October, with its last week being the fifth consecutive week of gains. Largely buoyed by the agreement by European leaders initially, Wall Street later saw declines on the back of MF Global’s bankruptcy, America’s first victim of the Euro debt crisis. Nonetheless, the Fed indicating its intention to support the housing market renewed buying interest again toward the fortnight’s end. Other indications included the maintenance of near-‐zero interest rates, as well as the slashing of growth projections. Bernanke also signalled the need to lower US unemployment rates, from inflation being the only satisfactory indicator. EU: Fast and Furious The Euro region’s weak growth going forward was confirmed, with both the PMIs for Manufacturing and Services coming in below expectations, at 48.9 and 47.2 respectively. The Eurozone’s agreement on measures to mitigate Greece’s debt crisis, the instability of the banking sector, and weak bailout fund helped global markets to rally early in the fortnight. However, sudden Greek calls for a referendum later reignited fears of the debt agreement falling apart. Markets later recovered slightly on the back of an unprecedented ECB rate cut, from 1.5% to 1.25%. Asia Pacific ex-Japan: Mirror to the West, but much going on Asian market movements largely followed the progress of Western events as usual. At the country level, Chinese equities have been in the green due to the slowdown in property sales and easing inflation leading to the government to embark on tax breaks and other measures to maintain growth. The Bank of Japan also intervened to weaken the yen, leading to the latter’s plunge upon the move’s announcement. Floods in Thailand caused the government to cut its 2011 growth forecast from 4.1% to 2.6%, with financial damage estimated at more than 200 million baht. A Nielsen survey also showed consumer confidence in Singapore hitting a 2-‐year low, reflecting the unsatisfactory global growth outlook.

SMU Political-Economic Exchange

AN SMU ECONOMICS INTELLIGENCE CLUB PRODUCTION

© Copyright 2011 SMU Economics Intelligence Club

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The Price of the Safe Haven By Tan Jia Ming, Singapore Management University In Part One, we explored the history of the Swiss franc, looked at how it became a safe haven currency and the price investors and the Swiss had to pay. Part Two sums up by first revealing the implications of the Euro debt crisis on the Swiss franc, followed by a discussion of the effectiveness of the Swiss’s remedy and finally, a food for thought on whether the Swiss are ‘reaping what they sow’.

Euro Debt Crisis and the Flight-to-Quality In light of the Euro debt crisis, back in 2010, the Swiss National Bank (SNB) has already started shoring up its reserves in anticipation of the franc’s appreciation. Even attempts from UBS to charge institutional investors for their accounts’ excess deposits proved to be futile as the charges were deemed negligible when weighed against the potential appreciation of the franc. The recent euro zone’s debt crisis revealed that as investors fled from Europe, the Swiss franc has inevitably become the safe haven to go to (see figure 1.3a). Needless to say, the massive inflow of liquidity resulted in the appreciation of the franc against the euro. The appreciation was deemed unhealthy to the extent that on 6th September 2011, the SNB declared that “the current massive overvaluation of the Swiss franc poses an acute threat to the Swiss economy and carries the risk of deflationary₁ development”. The declaration was accompanied by their commitment to maintain a minimum exchange rate of 1.20 franc per euro (see figure 1.3b), and the determination to buy “unlimited quantities” of foreign currency to defend against further appreciation of the franc.

Figure 1.3a Source: MetaQuote Database

Depreciation of EUR/CHF, i.e. the ‘flight-to-quality’, starting from late December 2009


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Figure 1.3b Source: MetaQuote Database A self-defeating policy? What the SNB has effectively done or aimed to do was to drive down the value of the franc through quantitative-‐easing (QE). Unlike the Bank of England back in 1992, the SNB is likely to have an easier time achieving their objectives as there are no limits to the amount of franc they wish to inject. However, doubts have surfaced with regards to the QE employed by SNB. While another round of the 1930’s ‘beggar-‐thy-‐neighbour’₂ devaluation is unlikely, the SNB might have inadvertently been digging a deeper hole for themselves and possibly, everyone else. This speculation is based on the assumption that in their attempts to defend the franc’s appreciation, SNB is likely to purchase French and German bonds while avoiding the Greek, Spanish and Italian’s paper. As a result, the yield spreads between the stronger and weaker European countries would widen, leading to further market fears and risk aversion, ultimately translating to further flight to the safe haven. In other words, the QE is potentially a self-‐defeating policy. And if the policy fails to hold, SNB would end up with huge losses which would worsen the political climate, given that losses on previous interventions have already sparked calls for the SNB president’s resignation. Reaping what They Sow At first glance, the Swiss may have been an innocent bystander, the reluctant safe haven that investors rush to whenever crisis beckons. However, as much as they claimed to disapprove of the status, one cannot help but realize that it is not all gloom. As attached to safe haven reputation is substantial tax income -‐ a significant source of its consistent budget surplus-‐ and more importantly, the ability to implement lower tax rates in other areas of its economy. With the banking secrecy regulations₃ playing a significant role in attracting investor funds, and a contradicting desire to reduce the inflow of funds exist, one may wonder why the Swiss are so adamant in preserving the privacy policy despite lobbies from the international community. As the saying goes, there is no free lunch in the world.

EUR/CHF’s immediate rally upon SNB’s declaration on 6 September


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Understanding the BRICs By Tang Manhao, London School of Economics Part Two of Two, this article gives readers a deeper look into what exactly are the BRIC nations and the factors augmenting their rise to prominence in the new global economy. Following where Part 1 left off, Russia, India and China will be elaborated on in this article.

Russia Since the collapse of the Soviet Union, Russia has been moving away from a centrally-‐planned economy to a market-‐based₁ and globally-‐integrated economy. Most industries have gone through a period of privatization, as the government strives to combat inefficiency and corruption that’s been impeding the country’s progress. Having said that, Russia’s economy is still very much concentrated and geared towards the commodity markets₂. The CIA World Factbook entry shows that in 2009 Russia was the world’s largest exporter of natural gas, the second largest exporter of oil, and the third largest exporter of steel and primary aluminum. This makes it vulnerable to boom and bust cycles that follow the highly volatile swings in global commodity prices. The country’s GDP growth for the year is expected to be more than 5%. However, investors should still be cautious, with long-‐term challenges including poor infrastructure, a shrinking workforce, and high corruption rate still to be tackled. India India’s political stability and economic liberalisation have attracted foreign direct investment (FDI), particularly over the last ten years, with cumulative FDI equity inflows into India over US$100 billion from April 2000 to March 2010. In 2007, before the world economic slowdown, the Indian economy grew at more than 9% and has shown resilience during the downturn, still achieving growth of over 6% during 2009 and annual growth of over 8% is predicted for 2010, according to the World Bank. At this rate, India is well position to overtake China as the fastest growing economy. India benefits from the fact that it is less exposed to the global economy and its banks remained relatively conservative, with low credit lines. With the country requiring less fiscal stimulus during the downturn than, for example, China, its growth may be seen as more sustainable. There are many opportunities for investors to benefit from this, particularly in logistics and other sectors, which will be direct recipients of expansion.

1 A decline in general price levels. 2 An expression in economics describing a country’s policy that brings it benefit at the expense of other countries. 3 A legal principle in which banks are not allowed to provide authorities personal and account information about customers unless under certain conditions (such as criminal charges).


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China As in the case of Russia, China has changed from a centrally planned system that was largely closed to international trade to a more market-‐oriented economy, fuelling rapid growth in the private sector. Reforms include the gradual liberalisation of prices, fiscal decentralisation, the development of stock markets, the rapid growth of the non-‐state sector, and the opening to foreign trade and investment. The most recent trade figures show exports up by 18%, year on year, and imports up by a staggering 56%. This confirms that domestic demand is robust. The country even managed to come out of the downturn relatively well. In 2008, when America’s economy stumbled, analysts said that China’s export-‐led recovery would suffer from a collapse in American spending. Instead, they decoupled from each other, with China achieving 8.7% GDP growth in 2009. China’s ambitions are high. Officials have even talked about a long-‐term goal of replacing the dollar as the global reserve currency. It is this aim for growth and further integration with the world that is spurring investment. Yet for western economies there are plenty of risks involved. The investment push is likely to herald an era of competition between developed-‐world nationals and state-‐owned Chinese companies. Bank lending is growing too fast, which may be fine if it is going into useful investments, but not if it is fuelling asset prices, and therefore a bubble. The risk of these bubbles and excess capacity will grow unless policy is tightened. Looking Ahead - Is this the BRIC Decade? All these facts point out that companies and governments in the developed world have to face up to the reality that there will be a further shift in the economic balance of power in the years ahead. “Leading global companies that fail to understand and optimize the opportunities in emerging₃ markets may lose out on significant revenue growth,” said John Nendick, Global Media & Entertainment Leader for Ernst & Young. It seems that the only way to help stabilize the global economy in the long term is by promoting the economic development of major emerging markets, particularly China and India. These countries are massive population centers, and the development of consumer classes in these countries will be the primary driver of global economic growth for the next few decades.

₁ An economy in which prices of goods and services are left largely to market forces. ₂ A market where raw materials or primary products are bought, sold and traded. ₃ A country which is experiencing large economic growth and is considered fast approaching advanced economies’ standards.


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Deflation in Japan By Lin Liye, Singapore Management University Japan has been plagued by a prolonged recession₂ for the bulk of the last 20 years. Ever since it experienced a spectacular crash in its Nikkei 225 stock index, wiping out over 50% of its value within two years, its economy has lost its vibrancy and remained stagnant. 20 years later, the stock index is still over 75% below of its peak value. This has coincided with two decades of depressed prices, or deflation₁, in the economy. All is not lost for Japan, however. The Japanese are a creative and smart people, and they have led the world in robotics and research in sciences despite the weakness in the economy. They have demonstrated stoicism in the aftermath of the March Tsunami disaster. These are highly capable people who, with strong leadership and urgency from the government in tackling the underlying problems, are able to bring their country out of its economic doldrums. Deflation will not be the only option for Japan if the right policies are implemented. Deflation is the sustained decrease in the general level of prices in an economy. It is accepted by most central banks that a low and stable inflation rate of around 2% is beneficial to economic growth, since it provides price stability. It does this by protecting the purchasing power of money, since prices will not gyrate wildly when there is low inflation. A low inflation rate also means lower real interest rates₃ (real interest rate is the nominal interest rate minus the expected or actual inflation rate), which lower the cost of borrowing and encourages entrepreneurs to take risks. Japan, however, has struggled to escape from deflation, with its inflation rate exceeding 2% only twice in the past two decades. Its economy has consequently suffered from low growth, and in 2011, China officially overtook it to become the second-‐largest economy, after the United States.

Source: CEIC Database

There are many reasons given for the relentless downward pressure on prices in Japan, and one commonly raised factor was the rapidly ageing population. The elderly has always been blamed for the sustained deflation in Japan because they are often retired or unemployed and do not earn income. As such, their purchasing power is not as strong as the younger and working populace. Coupled with a tendency to spend with more restraint than younger generations, with many preferring to window-‐shop instead, the result is a smaller market for goods and a drop in demand for consumer goods, which reinforces deflationary expectations. Also, because of improving healthcare services, the Japanese are enjoying higher life

93 95 97 99 101 103

1994 1997 2000 2003 2006 2009 2012

CPI

Year

Japan Annual CPI (Base year: 2005)


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expectancy rates. This means that the elderly will have to save more money for a longer retirement, which further decreases the propensity to consume. There are many consequences of prolonged deflation. In a deflationary environment, money not spent today is worth more tomorrow than today. This reduces the willingness of consumers to spend today, which further compounds the problem of deflation and perpetuates in a vicious cycle. In Japan, deflationary expectations are already entrenched in consumers, and surveys on households and firms have shown that they expect prices to continue falling in the foreseeable future. Also, because the same unit of money is worth more tomorrow, businesses will be less willing to borrow money to invest in capital, since the real value of their debt will increase. With a drop in both components of consumption (in the form of consumer purchases) and investment (in the form of business investments), national income has to drop correspondingly, and this slows down economic growth. Deflation is evidently not a good thing for Japan. Despite all efforts by the government to fight this problem, it has still failed to be effective in boosting the economy. So is it inevitable for Japan to be mired in recession and deflation? For the next issue, in Part 2, we will expand on the possible solutions that can be undertaken by the Japanese government to boost consumer spending and raise revenues to boost economic growth and inflation.

Gadaffi’s Death – Libya’s Black Gold May Do Little for Oil Prices By Brendan Chua, Singapore Management University

The liberation of 41 years of autocratic rule for Libya would signal new hopes and promises to the political landscape and economic struggles of a country reborn. However, the corporate world seems to be simply more concerned about where oil prices are heading. Global oil companies would almost certainly start considering how they may begin extracting Libya’s most prized asset -‐ light, sweet, paraffin-‐crude. The huge interest in oil prices is hardly surprising as the Libyan conflict was one of the important factors keeping upward pressure on Brent crude oil1. The civil battle against Gaddafi since the start of this year has spiked oil prices and the death of the former ruler may signal a trend reversal on oil prices. However, the end of the Libyan uprising is but a stepping stone in resolving its current crisis. There are many new factors to consider now before expecting oil prices to drop. Contrary to expectation, Gadaffi’s death is but one of them.

₁ Deflation is the sustained decrease in the general level of price in the economy. ₂ Recession is a period of temporary economic decline when trade and industrial activities are reduced, generally identified by a fall in GDP in two successive quarters

₃ Interest rate is loosely defined as the cost of holding money, or the cost incurred by holding cash instead of storing it in a bank.


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For a start, organising the country and its oil production activities will not be easy. The different opposition groups that led the uprising may not agree on a unified government. A common goal to rid of the former dictator has vanished and at least four different regional groups will have to decide how to proceed with talks to steer the country forward. This may prove to be a huge challenge for Libya. For the next eight months, a transitional government will run Libya while it organises an election for a 200-‐member assembly. This “general national congress” will be granted sole legislative powers to draft a constitution. Once a constitution is set, parliamentary and presidential elections will follow. This process could take years. Without an organised leadership in the coming months, the country will not be able to restore the oil production pass 500-‐600,000 bbl/d (barrels per day). This level pales in comparison to Libya’s pre-‐war output of 1.6m bbl/d. There are still many lingering doubts concerning Libya’s damaged oil-‐export infrastructures. There are also security problems that may surface. Perhaps the bigger question is how the state-‐run National Oil Company will be controlled as it is still in the hands of Gaddafi loyalists. It seems to be a longer than expected time before consistent supply of oil will be exported from the nation. This, however, is inevitable for a newly-‐governed nation. Then there is the issue of oil that has been supplied by Saudi Arabia since the Libyan crisis. At the start of the year, Saudi Arabia has been picking up the supply slack left behind by Libya’s cease in oil production. This may necessarily translate into a cut down in oil supply by Saudi Arabia once Libya resumes its own oil exports to pre-‐crisis levels. With the sluggish global economy forming a gloomy backdrop, it is certainly in the Saudis’ interest to cut back on production to maintain the price of crude at close to US$100/b. Therefore, there may be a negligible net change in oil supplies and the world may find oil prices stubbornly resist breaking through current support levels to go lower. Fundamentally, investors would look towards global demand as an indication of oil prices. Consumption in the US looks to fall as consumer sentiments remains bleak. Their European counterparts are echoing the same sentiments although there could possibly be a slight upturn in Japan’s consumption as the massive scale of reconstruction works in the aftermath of March’s earthquake and tsunami will increase the consumption of oil-‐powered machinery. China’s growth has been decreasing for the first eight months of 2011 and the government will look to improve energy conservation and efficiency in order to meet its five-‐year plan of carbon emission reduction. Given that a general decline in global demand for oil seems likely, prices may ease in the longer term. Still, it is worth considering how the strength of the US currency will impact oil prices in the shorter horizon. Following the slowing US economy, markets may start to price in further quantitative easing in the US which leads to a weakening dollar. This will result in upward pressure in dollar-‐denominated oil prices, continuing to bleed the oil-‐guzzling nation. However, the effect of a weakening dollar is not expected to outweigh the downward pressure for oil prices stemming from the slumping global demand. All these considerations on demand and supply may be counter-‐intuitive for some. Energy investors may argue that bleak market sentiments have been in place for the past couple of months now and market forces would already have discounted a decline in global demand in the oil prices. It would then be argued that current Brent prices are significantly impacted by market sentiments rather than fundamentals. This, however, would be debatable.


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Prior to the subprime crisis of 2008, investors had excess cash which prompted larger capital flows to riskier investments such as energy commodities. As such, speculative trading2 was one of the main reasons for driving up oil prices for West Texas Intermediate (WTI), a grade of crude oil commonly used as a benchmark for oil pricing, to an unsustainable level of US$140/b. However, the current global economy paints a very different story. Investors have a much lower risk appetite as they flee to safe havens such as US treasuries and traditionally strong currencies. Therefore, it can be argued that current oil prices are going to be largely influenced by fundamentals of supply and demand.

Figure 1: Price of Brent Crude Oil (USD/bbl) Source: Financial Times

If this is so, then oil prices can be expected to show a significant decline in the next 12 months. Oil supplies will largely stay unchanged but demand for oil may take a dip. The effects of global demand are already creeping into the falling price levels of Brent Crude Oil (See Figure 1) as the Greek drama unfolds rapidly and banks are already expected to take a 50% haircut3 on Greek debt. When European stocks tumble, the US will be dragged into economic turmoil as well. These fundamental drivers may push oil prices below the US$100/b mark, but even this will prove little consolation once a global recession hits. For the average Libyan, October 20 signifies the birth of a new nation and a monumental change to the livelihood of millions. Yet, to most parts of the world, the end of Gaddafi’s rule means little more than a marginal impact. If there is any, it will be mainly on oil prices. Indeed, his historical death would already feel like a distant memory. After all, there are a plethora of drivers for oil prices. Gaddafi’s death may not be remembered as one of them.

1 A type of crude oil (unrefined oil) that is commonly used as a benchmark to price other types of oil. The other commonly used benchmark is West Texas Intermediate (WTI). 2 Traders often trade energy futures contracts based on their speculations for where oil prices are heading. This form of trading is risky and it is considered a high-‐yield trade. The direction of futures prices are often seen as a leading indicator for spot (current) oil prices. 3 The percentage at which an asset’s value is reduced for the purpose of calculating capital requirements and collateral levels. In this case, it is the percentage decline in market value for Greek debt and other securities that are held largely by other European banks.


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In the next issue of SPEX…

The S&P 500 is a free-float capitalization-weighted index published since 1957 of the prices of 500 large- cap common stocks actively traded in the United States. It has been widely regarded as a gauge for the large cap US equities market The MSCI Asia ex Japan Index is a free float-adjusted market capitalization index consisting of 10 developed and emerging market country indices: China, Hong Kong, India, Indonesia, Korea, Malaysia, Philippines, Singapore, Taiwan, and Thailand. The STOXX Europe 600 Index is regarded as a benchmark for European equity markets. It represents large, mid and small capitalization companies across 18 countries of the European region: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the United Kingdom. Correspondents Shane Ai Changxun Ben Lim [email protected] [email protected] Singapore Management University Singapore Management University Singapore Singapore Tan Jia Ming Lin Liye [email protected] [email protected] Singapore Management University Singapore Management University Singapore Singapore Tang Manhao Brendan Chua [email protected] [email protected] London School of Economics Singapore Management University United Kingdom Singapore Kwan Yu Wen (Designer) [email protected] Singapore Management University Singapore Everything in this document and/or in this website is copyrighted by law and cannot be used without the written permission of its owner/publisher. It is forbidden to make digital copies or reproductions, however you may however use the information as reference material and it may be physically printed for personal use. You may also quote parts of the content of this publication, digitally or physically, if the source and author is clearly stated, together with the copyright information. All views expressed in this publication are the personal opinion of the researcher(s), do not constitute a buy or sell recommendation on any instruments, and in no way reflect the opinions, views, or thoughts of SMU and other abovementioned universities, and unless specified, of any other student clubs. All logos and/or images on these pages belong to SMU and the respective third party copyright and trademark owners. SPEX, affliated clubs and the covering researcher accepts no liability whatsoever for any direct or consequential loss arising from any use of this document or further communication given in relation to this document. SPEX is the brainchild of current New York University undergraduate Mr. John Ang, further developed by SMU students for the benefit of both SMU and non-SMU students.

Part 2 of Deflation in Japan & much more…

SPEX Issue 5

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