Financial volatility poses problems for Chinese markets

Oliver Dyson

Since the 2008 crisis, sovereign debt from the Emerging Markets has been on a steady rise. From the 146% to 217% increase in public debt across the IIF 21 countries (compared to aggregated GDP), it is clear that developing nations are more indebted today than at any point since the crisis. The same can be said for China. In an article published in November, I talked about the current issue of China’s rising credit binge. Keeping this in mind I thought it would be interesting and worthwhile to keep up with the developments in financial markets since then. This is especially pertinent given the importance of strong Chinese financial markets to the health of the global economy.

If we are just considering the debt pile, the picture still looks bleak for the nation. With an estimated $36trn of debt looming at the end of 2017, policymakers have the task of balancing strong GDP growth with deleveraging, to avoid excessive bubbles and issues for the future. As mentioned in my previous article on the subject, an interest rate hike was to be expected to combat the borrowing expansion, which indeed occurred in mid-December as the People’s Bank of China (PBOC) raised its 7-day and 28-day reverse repurchase agreements rates by 5 basis points. The other main development in the past few months is that the composition of the credit expansion can be pinpointed to a specific sector: shadow banking.

Playing a crucial role in the US 2008 Financial Crisis, the shadow banking system refers to the financial intermediaries who are not subject to regulatory oversight as well as the unregulated activities that are performed. Examples of these institutions credit hedge funds, money market mutual funds and securities lenders. As was the case for the US 10 years ago, economic growth is underpinned by borrowing in this sector, despite the financial risks that are mounting. To put the size of this system in perspective, the outstanding assets owned by Chinese shadow banks at the end of last year stood at $4.3trn, or 4 times the size of the Mexican economy. This came after a growth in their assets by $555bn in 2017, resulting from private companies resorting to other forms of financing following a general crackdown on credit. The issue for policymakers is that if a hard regulatory approach is taken to curb financial risk, a contraction could have serious implications for GDP. Indeed, the PBOC has been quoted as wanting to double GDP per capita by 2020, as well as clean up financial sector risks in the next three years. Can strong growth occur at the same time as reducing financial sector risk?

Earlier this month, regulators released policies that suggest that it can. Some economists argue that through a soft regulatory approach of tightened bond supervision and insurance, financial risks can be brought down to Earth. The three main policies are as follows. First, entrusted loans will face further scrutiny, with banks being ordered to limit their exposure to these products. Entrusted loans are made from one corporation to another with a trustee or agent acting as an intermediary, and they make up the fastest growing sector of shadow banking, according to BMI Research. Second, rules have been imposed aimed at preventing insurance firms from extending loans in the guise of equity investments using buyback agreements, a key component of rising local government debt. Finally, bond trading will face further supervision, with traders having to meet more stringent liquidity requirements. It is worth considering the effect on banks and firms going forward, given that cheap forms of financing are drying up or being cracked down on; it is likely that private investment could slowdown in the coming years. The aforementioned policies have worked in curbing shadow bank activity, however, with lending in the sector down by 90% in January.

In answer to my previous question, President Xi Jinping publicly stated at the end of last year that credit growth must be reigned in by focussing on financial risks, not deleveraging, to prevent any asymmetric shocks to the economy. Indeed, it is important not to end up in a Japanese-style ‘Lost Decade’ resulting from an aggressive policy decision.

Yet another issue facing the Chinese economy that is worth mentioning is the ongoing trade dispute with the USA. President Trump’s ‘America First’ trade policy will ‘hurt the world economy’ and ‘damage the recovering momentum’ of global growth, Beijing stated on Wednesday. This comes as a response to two US Commerce Department reports suggesting tariffs of up to 24% on Chinese products on Tuesday, which will be considered by Trump for a new round of sanctions. New sanctions of this magnitude would result in slower growth for China, while asset prices would likely drop at the news.

Developments in the USA tend to feed through to Chinese markets. This has certainly been the case with last week’s stock market rout, which saw falling equity prices at the news of Fed interest rate hikes after many years of stability. There are many fears that an era of cheap credit and stability are about to close, and this uncertainty is showing in Chinese markets, which have been some of the worst hit globally. The Shanghai stock Index lost 11% of its value over two weeks, while the blue-chip CSI300 index fell by 10%. This has been exacerbated by margin calls, and the ongoing campaign to reduce financial sector risks mentioned previously. Volatility has also risen; the iVx, a widely-used measure of fear in Chinese equities, surged to 33.06 last Friday, the highest in a year, while CSI200 futures saw their volume increase by 50%. This is significant given that these futures are used to short the blue-chip index, indicating a loss in confidence across the board. Many Exchange-Traded Funds have faced trouble as well. Credit Suisse, Nomura, Deutsche Bank and other big names have all closed Volatility-based ETFs after facing up to 80% losses in value last week. This is especially a problem given that ETFs are readily available to retail investors, who have seen a large loss in their portfolios on aggregate, to the tune of $USD 4bn. The full effect of the rout will only be see after the effects ripple through the OTC derivatives market, which will be a further test of the post-crisis regulation structure.

With what some describe as an end to the era of low volatility, the PBOC’s goal of reducing financial risks going forward is looking more difficult to achieve. As I posited in my previous article 3 months ago, the Chinese economy could grow sustainably only if these systemic risks could be curbed. Given the recent developments in global markets, the regulatory system will need to work extra hard so as not to spook the shadow banking sector.

Indonesia – a worthy investment?

Danielle Cuaycong

Indonesia, Southeast Asia’s largest economy, has experienced an increase in its sovereign credit rating. Indonesia’s upgrade to an investment-grade level Standard & Poor in May 2017 has indicated for the first time since the 1997 Asian Financial Crisis that Indonesia has an investment-grade rating by all of the ‘Big 3’ ratings agencies. Due to Indonesia’s increasing resilience to external shocks, the rating on the long-term, foreign currency-denominated debt was increased by one level to BBB with a stable outlook, leaving it on the same level as Portugal and the Philippines. Alongside this, the combination of the persistent and strong economic growth (5.19% in the fourth quarter of 2017) and increasing foreign exchange reserves were major components for the upgrade. Outlook for Indonesia is positive with expectations of GDP growth of 5.4% in 2018 and 5.5% in 2019.

Fitch Ratings noted that monetary policy has been “sufficiently disciplined to limit bouts of volatile capital outflows during challenging periods.” Thus, this is an indication that the demand for Indonesian debt has increased, with 25.5 trillion rupiahs being sold this month, beneficial for President Joko Widodo who had plans to raise 194.5 trillion rupiahs in the first quarter of 2018. With a higher rating, Indonesia will expect to see an influx of investors. As the confidence of investors significantly increases, borrowing costs for Indonesia will decrease, raising the level of foreign direct investment (FDI), which reached peak levels at 109.9 trillion rupiah in the second quarter of 2017. The upgrade will result in keeping yields low and will help control the increase in Indonesia’s risk premium. Therefore, Indonesia has strengthened its position in Asian bonds, with local notes increasing 17% over the past year compared to 12% for emerging Asian bonds.

The ultimate question lies – should investors be moving towards to the Indonesian bond market? There are significant issues with this. Firstly, Indonesia’s economy is incredibly reliant on commodities.  With an HSBC trade report predicting that Indonesia’s exports will be mainly composed of agricultural produce until 2020, there is a significant need for Indonesia to diversify more to increase the number of investors. Additionally, with expectations for the US to pursue three interest rate rises in 2018, this may cause capital to flow out to Indonesia. However, it is important to note that it is likely a recovery will occur once the increases in rates have been announced. Alongside this, the upcoming elections (2018 local elections and 2019 presidential election) may pose a hindrance to Indonesia’s strong economic performance.

In December 2017, the rupiah-denominated bond ‘Komodo’ hit the London Stock Exchange. Presently, 16 active Indonesian rupiah (IDR) are on the London Stock Exchange, enticing organisations including Barclays, Inter-American Development Bank and the European Bank of Reconstruction to be repeat issuers of IDR bonds. A further indication of the potential positive economic prospects for Indonesia is its decreasing reliance on price-volatile commodity-based growth, with a change in direction towards more industry-based growth. The ultimate benefit of this is the removal of foreign exchange currency risk.

Indonesia’s growth prospects seem to be positive, with GDP growth set to exceed 5%, which means Indonesia will maintain its position as one of the fastest growing countries in the G20. There are expectations that investment will rise with increased spending on infrastructure, reduced borrowing costs and more structural reform. However, it is important to note that Indonesia still has a low level of government revenue, with only four other Fitch-rated sovereigns having lower government revenue as a percentage of GDP.

The Iran nuclear deal

Harry Jones

In 2015, Iran signed a key nuclear deal with six major countries, the US, UK, France, Russia, China and Germany. The six major countries agreed to lift some of the economic sanctions on Iran on the condition that Iran limited its nuclear energy programme. The fear was that this programme would be used to create nuclear weapons in Iran. However, this deal has been under constant threat ever since Trump entered the White House.

In October, President Trump labelled it “the worst deal ever”, and said that Iran had broken parts of the agreement. He accused Iran of encouraging extremism in the Middle East and said that their ballistic missile programme is a regional security threat, despite the fact that the missile programme does not fall under the nuclear deal. The EU’s foreign policy chief even admitted that Iran had not violated the deal and no renegotiations could be done. Trump has given European diplomats a 120-day deadline after which, if nothing has been done, Trump will step in. Despite this, Iran’s foreign ministry spokesman has said that their missile policy is not negotiable.

Europe and the US want stability in the Middle East and North Africa, combined with political strength and economic prosperity. It is widely agreed that new improvements need to be added to the deal with Iran so that aggression can be contained and the missile programme is restrained. There are three main things which need to be done in order to prevent escalating problems in the region. Firstly, there needs to be an agreement to cut Tehran’s ability to support extremist groups. This will appease Trump who believes this is becoming an increasing problem. They also need to reduce the ability of the Islamic Revolutionary Guards Corps, which protects the Islamic Republic system, to incite conflict in the region. Finally, there needs to be a limit to the missile programme so that it is brought down to a reasonable level. This will defuse tension in the area and will prevent innocent neighbouring states from being targeted.

There is some hope that there will be progression in the region in the future. There is a new reform programme in Saudi Arabia which should have a regional impact if it has its desired effect. However, there still needs to be support from the rest of the region and the EU for it to be successful. European countries have now begun to put pressure on Iran’s missile programme after Trump’s comments. German, French and British ministers along with the EU foreign policy chief agreed to hold talks with Iran on the missile programme. However, with the comments from Iran’s foreign ministry spokesman suggesting that it will not be negotiable, it seems that they are a long way from an agreement.

Will Duterte lead the Philippines to economic success?

Danielle Cuaycong

With the contentious drug issues in the Philippines capturing newspaper headlines across the world, it is natural to question the success of President Duterte’s regime. However, despite an array of discouraging foreign opinions on Duterte’s harsh words and political actions, he still remains significantly popular after a year in office with many stating they still trust and approve of their leader. Even more surprisingly, Duterte is succeeding on the economic front, with the Philippines currently growing faster than China. In the third quarter of 2017, the Philippines economy grew at an annual 6.9%, slightly higher than China’s third quarter annual growth rate of 6.8%. According to the World Bank, the Philippine economy is expected to advance at a rate of 6.7% in 2018, enabling them to gain the position of the world’s 10th fastest growing economy. However, a fundamental question remains – what does the future hold for the Philippines and how will Duterte maintain this economic growth?

One strategy that Duterte intends to pursue is to engage in a more multilateral diplomatic turn with aims of closer economic cooperation with China. These renewed ties with China will allow the Philippines to make considerable economic gains. Duterte has cited that he will increase agricultural trade and tourism since, in previous years, China banned Philippine banana imports and discouraged its citizens from visiting the country. This long-term cooperation plan with at least $24 billion in economic deals prompted him to push aside the enduring maritime issue with Beijing over parts of the South China Sea and settle on focusing on rebuilding the relationship between the two countries. Additionally, President Li of China has stated that they will give 150 million Yuan ($422.6 million) in grants to rebuild the war-torn southern city of Marawi.

Duterte’s “Build Build Build” initiative (a group of mega infrastructure projects totaling $160 billion) is set to occur with the intention of increasing economic growth by easing access to markets and business opportunities across the country. Projects include implementing complex road networks, long-span bridges, flood control and public transport investments. Manila – the capital of the Philippines – was ranked 3rd for the worst city traffic in Asia, and strategies like this will enable people to see an increase in productivity and efficiency, providing long term economic growth.

In December, the Philippine Congress approved a tax reform bill, TRAIN (Tax Reform for Acceleration and Inclusion), which is expected to raise revenues of more than $1.8 billion in the first year. This is in an attempt for Duterte to use the increase in tax revenues to guide the Philippines into a “golden age of infrastructure” by increasing its annual spending on infrastructure from less than 3% to 7% of gross domestic product. These reforms include lowering personal income taxes, raising taxes on petroleum products, automobiles and implementing taxes on sugar-sweetened beverages. This government tax reform has had positive benefits, resulting in Fitch Ratings agency upgrading the Philippines’ sovereign credit rating.

However, a fundamental issue with the Philippine economy is the fact that these economic policies alone are not enough to deal with the long-standing issues that persist after many years. With bureaucracy, corruption and security issues being the norm, Duterte has to ensure that these issues are truly dealt with to see a long-term change in the economy. Despite the fact that lawmakers have stated that 70% of the revenue generated by the tax reforms will be allocated to infrastructure and the remaining amount for social services, it is unlikely that this will occur due to the severe corruption that ripples through the Philippine economy. Additionally, Charito Plaza, the director of the Philippine Economic Zone Authority (PEZA), stated that about 500 billion pesos ($9.7 billion) was at risk because of bureaucratic delays in implementing economic zones, diverting potential investors to other countries.

Thus, in order for the Philippines to maintain its strong level of economic growth, Duterte must push through with his economic policies, alongside dealing with the corruption that stifles the government in order to see this recent economic success turn into a growth miracle.

Is the ‘Putin List’ a real issue for Russia?

Ollie Dyson

The USA’s recent release of the ‘oligarch list’, a treasury report on 210 of Russia’s richest and most influential businessmen (including details on their links to Putin) has sparked fresh worries of future sanctions. Indeed, there are already a multitude of American and EU-type restrictions on several Russian banks, and the western companies that do business with them. Significantly however, many top fund analysts are maintaining their exposure to many top Russian equities and assets – why is there still confidence in the face of looming political action?

A brief look back at Russia’s economy over the last 4 years shows a period of stagnation. Low oil prices, and EU sanctions resulting from the Crimea annexation culminated in recession from 2014-2016. It has only been since 2017 that the outlook has looked less bleak: global oil prices have finally begun to pick up again, which is an economic lifeline for the nation where 50% of exports are petroleum-based. The Central Bank has forecasted an increase in GDP growth from 1.2% in 2017, to 1.8% in 2018. Goldman Sachs on the other hand is painting a much more optimistic picture for growth, with forecasts of 3.3% – again, mainly driven by oil’s three-year peak at $70 a barrel. Other indicators point to a strong recovery too – price inflation is currently at record lows between 2.3 and 2.5 percent, well below the targeted 4% figure. Low inflation breeds two things: increased consumption, and room for the central bank to stimulate the economic through interest rate cuts. The central bank said last month as it reduced the key rate to 7.75 percent from 8.25 percent that it expected inflation to increase back to the 4 percent target by the end of 2018.

Equities are also in a favourable position. With an average P/E ratio of 7.1, Russian shares are currently priced very cheaply despite the country returning to growth, facing high consumption, and expecting an interest rate fall. Of course, this may be explained by relatively low confidence arising from several factors.

Firstly, the Russian financial sector is looking weak, where private banks are collapsing at an increasing rate. In 2017, two of the biggest institutions Otkritie and B&N Bank failed within weeks of each other. Moreover, 2,600 of around 3,000 registered banks have lost their licences over the past 17 years. Some claim that The Bank of Russia, the country’s central bank, has brought about an unfavourable environment for banking and is at the root of these issues. 5 years of stagnation following the 2008 crisis saw no consolidation, only strict regulations that make prohibited transactions and asset stripping more profitable than merging. Excessive regulations on legal operations and heavy reporting standards make business uncompetitive – Russian banks for example must employ 5 times as many employees than US ones, to keep on top of reporting. The move to excessive regulation has actually facilitated riskier trades and more frequent use of fake collateral, overstated asset values, and money laundering (which was partly exposed in the 2016 Panama Papers), in a bid to garner more profits. Couple these activities with large and pervasive balance sheet holes covered up by high oil prices (prior to their crash in 2014 of course), and it becomes clear why the majority of the top 10 Russian banks were nationalised in 2017. Now, only one (Alfa Bank) remains.

The Bank of Russia’s decision to buy many of the struggling banks may have staved off a domino effect in the financial services industry. Otkritie needs roughly 450 billion roubles to be rescued from a capital shortfall, whereas B&N needs 300bn. It is interesting to consider how these balance sheet holes were amassed. The Central Bank’s answer to the financial crisis was the ‘Financial rehabilitation program’ – allowing banks to grow rapidly through acquisitions of other smaller banks with cheap state financing. However, as Sergey Aleksashenko, the deputy central bank governor in the 1990s, argued, “you cannot build a good bank out of 10 bad banks”. Now, many of the struggling banks have been directly nationalised, which poses additional problems. The huge cost to the central bank may push up inflation and present a conflict of interest in who gets a loan and who doesn’t, skewing market signals. Moreover, private banks may need to take on riskier trades to make a higher return against the state-owned behemoths.

The primary issue of many investors, however, comes out of the US treasury department’s report on the 210 richest oligarchs in Russia and their ties to the Kremlin, dubbed as the ‘Putin List’. While no actions have resulted so far, it is expected that additional US and EU sanctions are to be placed on those not already persecuted. With many of those mentioned being the owners of Russia’s largest companies, there is the increasing sentiment that Russian industry and investment may suffer if such sanctions go ahead: VTB and Sberbank (Russia’s two largest banks) may indeed be excluded from the Swift international interbank payment system, which would greatly restrict cross-border transactions. Western fundraising may also prove much more difficult if action is taken, shown by a recent release of bonds by companies such as Alfa-bank, Polyus and Rosal, to pre-emptively secure financing as a precaution.

Clearly then, the Russian economy may need structural change going forward. In actual fact, however, markets have seen little adverse reaction to the Oligarch list. The Moscow Stock-Exchange Dollar-denominated RTS Index was up by 1.15% on the 30th of January, whereas the rouble-based MOEX Russian index was up by 0.3%. A likely explanation for this was the US’s statement that it would not immediately impose the new sanctions on Russia. Danske bank analyst, Vladimir Miklashevsky, posits that “Really, a ‘black swan’ has not appeared, but the message of a worsening of bilateral relations is quite clear”. Many investors are actually set to increase their exposure to Russian stocks. Kathy Collins of Aberdeen Standard Investments notes that “If you take away the politics for a second, fundamentally these are good companies – they have survived lower oil prices, they have very low leverage, and we have been happy to hold them.” Moody’s statement on Tuesday that Russia’s economy is resilient enough to weather the new round of Western Sanctions lead to a possibility of its sovereign bond rating being upgraded by the end of the year.

To add to this analysis, some argue that equities are only cheap at present as they are pricing in the bad news of sanctions ahead of time. There indeed may be a dichotomy between people’s worries and the fundamentals that are quite healthy. Manulife senior credit analyst Richard Segal has quoted that sanctioning the individual oligarchs, not the companies, has no practical implications. It may have more of a diplomatic impact rather than a market response. If we take this view into account, while considering the effect of past sanctions, we may be able to estimate the effect on markets of any future sanctions. Last summer, when the U.S brought in new sanctions, the dollar-denominated index RTS fell to multi-month lows: it finished 2017 at flat levels, compared to the emerging market index MSCI, which increased to a drastic 34% at the end of the year. The first round of sanctions in 2014 caused an even larger market impact and caused huge selloffs across Russia’s currency, bonds and equities markets.

With strong fundamentals for many companies, it may be insightful to look out for the next round of US or EU imposed sanctions on Russia, which shall likely cause share and bond prices to fall. It may then prove profitable to buy these already cheap assets, given the underlying strength of the economy. While the banking issues touched on earlier are pressing, the central bank has managed to stave off a domino effect with the rounds of nationalisation, and it plans to sell off many of these banks within the next three years. Either way, while keeping a close eye on the financial sector, certain Russian equities may provide good returns following potential sanctions – something to look out for.

Is rising inequality restraining Indian growth?

Harry Jones

The World Inequality Report 2018 has raised concerns over the prospects for the Indian economy. The report presents an overview of inequality worldwide, showing that inequality has been rising in most regions, but with different magnitudes. Indian figures appear to be the most worrying, especially with the increase in the share of income going to the top 10% of earners. During the period of 1980-2016, the top 10% saw an increase in their share of income from around 30% to 55%. This represents one of the greatest changes worldwide especially when compared to the West (Europe saw a small increase from 32% to 35%). Alongside this, the bottom 50% in India have seen their income share falling since the 1980s. This presents a significant problem to the Indian economy, which needs to be dealt with before it spirals out of control.

Although real adult income has been growing, the gap between the top and bottom earners has never been so apparent. India as a whole is represented by the bottom 50% and the top Indian earners are in general less prominent in the world’s richest list. This might suggest that India has made little progress. The government is struggling to reduce poverty with a growing population, which suggests that the policies put in place are not having the desired trickle-down effects. The Indian government cannot simply embrace the new economy which only benefits the rich, it must provide policies which can support the lower classes within the economy.

A 2016 McKinsey report highlighted the opportunities for transformation in India, which could help the economy grow sustainably and lower poverty levels. McKinsey show that around 56% of the population lack the basics such as clean water, sanitation and housing. Therefore, they suggest that policies need to be put in place which create jobs and support the farming sector by increasing productivity. On top of this, cities need to be converted into sustainable living spaces with access to clean water, utilities and green spaces. This will mean that basic living conditions will become more accessible to the bottom 50% in India and will help to lift people out of poverty. McKinsey highlights the potential of Indian women as one of the main future drivers of the Indian economy. They show that women only contribute 17% of Indian GDP. Policies need to be put in place to decrease the gender gap which can help to unleash the economic potential in India.

With these policies, inequality can be reduced and growth will be promoted. The middle class must be supported by harnessing new technologies and using them to create productive jobs. India has been consistently rising in recent years in the Global Competitiveness Index, where it has risen from 71 in 2014-2015 to 40 in 2017-2018. This suggests that changes are being made, but the Indian government must continue to pursue new policies which reduce inequality in order to provide sustainable economic growth.

The future of investing in Zimbabwe

Danielle Cuaycong

When Robert Mugabe stepped down as President of Zimbabwe in 2017 after an extraordinarily long four decades, people turned to the new President Emmerson Mnangagwa (nicknamed “the Crocodile”) in the hope that he would help recuperate the diminishing finances, reduce corruption and increase foreign investment in a country that once boasted massive potential.

Firstly, perhaps a question to ask is how the Zimbabwean economy tangled itself into such a mess? In 1980, when Mugabe was appointed as the first Prime Minister of the recently liberated Zimbabwe, an atmosphere of happiness and confidence was echoed around the world. After 14 years of rebellion against the Crown (which was led by Ian Smith), people instilled their belief in him that he would guide the country towards “democracy”. Although Mugabe was even nominated for the Nobel Peace Prize the subsequent year, his issues as a leader became apparent, using bribery, intimidation and ruthlessness in order to hold on to power. Between 1983 and 1987, the Gukurahundi massacres of Ndebele civilians carried out by the Zimbabwe National Army led to 30,000 civilian victims.

Economically, Mugabe’s threats on nationalising the country’s leading industries led to a significant decrease in foreign direct investment. Additionally, the implementation of the Land Acquisition Act in 1992 enabled the government to lawfully deprive white landowners of their property and redistribute it to the indigenous population. In 2000, 4000 white farmers were forced to give up their land and with this land; Mugabe often gifted these assets to friends, instead of using it for its sole purpose. In numerous cases, the fertile land fell into severe degradation, prompting acute food shortages within the economy, increasing the need for imports (alongside the desire for money printing). In 2008 and 2009, the state’s central bank printed vast amounts of the Zimbabwe dollar to fund the government’s budget deficit, prompting inflation to increase significantly, with monthly inflation reaching 7,900,000,000% in 2008 and prices doubling overnight. Thus, inequality was significant with many Zimbabweans becoming instant billionaires but some left starving, as their money was deemed worthless due to the hyper-inflation. Although inflation settled down once the government used the US dollar as its main medium of trade instead of the Zimbabwe currency, inflation is still at 348%.

Thus, reform is undeniably essential for the Zimbabwean economy. Although the new President Emmerson Mnangagwa is already deemed to be controversial, he has already promised to repeal the indigenisation law from all industries except platinum and diamonds. This law gave Zimbabweans the right to take over and control foreign-owned companies in Zimbabwe. Additionally, he has pledged that local businesses will be permitted a tax amnesty on interest and fees, enabling them to free their debts and focus on the growth of their companies. Alongside this, he has said he would invite foreign direct investment in an effort to encourage more job creation and has expressed his desire for the EU and the United States to remove the sanctions against top military and Zanu PF figures. In an attempt to fix the damage that was caused with the white farmers losing their land, he stated that he would be “committed to compensating farmers from whom land was taken.” Moreover, Mnangagwa has plans of focusing on the natural resources (diamonds, platinum and lithium) that Zimbabwe has in abundance in order to boost the economy by 4.5% in 2018.

Although Mnangagwa has pledged to implement numerous policies, which should boost economic growth and fix the issues that have cracked the economy, he also needs to focus on fixing the ‘democratic’ system that has been put into place. If corruption still ripples through the government, foreign direct investment will still disappoint due to the hesitancy of investors. However, the political side does not look positive since the new Justice Minister Ziyambi Ziyambi has rejected calls for electoral reform, asserting that there is no need. Thus, one could argue that it will be difficult to expect significant economic change if the political side will not see any reform.

To conclude, although Zimbabwe is not a market for bond investors, Zimbabwe will receive significant temptation for global equity traders due to Mugabe’s departure as President and the fact that the new President Mnangagwa will implement new policies.

India’s promising outlook for 2018

Oliver Dyson

After a slowdown in growth in 2016 resulting from Prime Minister Narendra Modi’s controversial demonetisation program, 2017 (and indeed the 2018 forecasts) looks promising for Asia’s third largest economy. Amidst global GDP growth of 3.7%, India is expected to achieve growth of 7.4% in 2018, placing it as the fastest growing emerging market globally, and as an attractive investment location. Of course, there are ever-present risks bubbling up under Modi’s administration that need to be highlighted.

To start off, at the current pace the subcontinent looks set to become a $5tn economy in 8-9 years, according to the Indian Commerce and Industries Minister Suresh Prabhar in a statement on Wednesday. At the same time, the current unemployment rate stands at under 4%, with 15 million jobs being added every year. A rising middle class that’s expected to more than triple to 89 million households by 2025 is an equally exciting prospect, as private banks can look forward to a higher numbers of deposits from a largely unbanked class. India’s largest bank, HDFC, has shown growth in earnings of over 20% a year for the past two decades, a clear example of the potential middle class that investors can capitalise on. With this in mind, some are arguing that India’s growth is at an inflection point, implying higher future growth still to come. One of the core structural drivers of this growth is urbanisation; when urbanisation rates in districts or in states cross the threshold of about 35 percent, productivity benefits start to kick in, posited by Anu Madgavkar, a partner of the McKinsey Global Institute. Higher GDP per capita results as the dense cities suddenly get better connected with the rest of the world and more integrated with markets. In India’s case, the urbanisation rate will cross this threshold for many of its cities over the next 10 to 15 years. This point is especially poignant when one considers that by 2030, India’s top 5 cities will have economies comparable to middle-income countries; Mumbai for example should have a GDP larger than Malaysia’s.

Prime Minister Modi may take some of this credit with the recent implementation of the Goods and Sales Tax (GST) – India’s new nationwide value-added-tax system – which replaced a previously complex system of national, regional and local taxes. The new system has been praised by industry leaders, who argue that the overhaul will encourage greater efficiency by putting an end to the “tax on tax” issue that hurt the competitiveness of India’s manufacturing exports. Indeed, some analysts have estimated the GST could boost GDP growth by up to 2% a year, once the creation of a nationwide single market is achieved. It’s no wonder that the overhaul has been described in Indian media as the ‘biggest tax reform since independence 70 years ago’. With this in mind, it is also significant to point out the investment potential present here. The top 10 emerging market tracker funds have increased by a large factor in 2017, up in the range of 52-74%. IShares MSCI India Small Cap, which tracks companies in India with small to mid- market capitalisations, has seen year on year growth of 60.5%. With US equities trading at a premium after a 9-year bull market, these funds may prove an attractive alternative. Paul Quinsee of the J.P Morgan Asset Management division has confirmed this view by stating that “We still see more upside in emerging markets, Europe, and Japan than in the US”.

Of course, no prospect comes without its risks. While the GST has much potential, it is still undergoing many revisions, amid concerns that it has effectively collapsed after its first weeks of implementation in late 2017. The tax overhaul was set in place just 3 months after parliament agreement, before many say its IT backbone (Infosys) was fully developed. Commercial activity has slowed down as a result, with tax documentation becoming much more arduous and time consuming. The export sector has also been hit by the reforms. Beforehand, any exports were exempt from taxation, and this policy is still in effect. However, the difference that the GST brings is that companies that export their products must pay the initial levy, and then apply for a refund after the fact. This would be manageable if the IT system was fully equipped; unfortunately, severe delays are resulting from processing errors in the software. In the tea-exporting town of Coimbatore, tea exporters face 5-months’ worth of outstanding refund claims, which ties up working capital and reduces trading. March 2017 saw year on year export growth of 28%. This figure fell to just 1% in November.

Meanwhile, a $207bn pile of bad debt is being compounded by rising delinquencies in the affordable housing sector, one that has been recently touted as a ‘growth driver’ by Prime Minister Modi. After calls to increase lending to poor Indians, a potential subprime issue may pose a risk to banks, with 10.4% of all non-performing housing loans being below $3100, an increase on recent years. Slowing house price inflation of 8.5% (the lowest in 6 years) could crystallise this worry further. Indeed, India has the second-worst commercial bad-loan ratio in the top 10 economies (behind Italy) at 9.6%. For comparison, China’s is 1.7%.

Overall, India’s path forward does not come without its traps and pitfalls. The performance of the economy going forward clearly depends on Modi’s future policies, which is why the release of the national budget on the 1st of February is important to look out for. As it stands however, India is looking like one of the most promising growth stories in the emerging markets in 2018, with certain indices and funds offering good returns for the year ahead.


South Africa’s need for a new direction


Harry Jones

The S&P shook South Africa on Friday 24th November when it announced the downgrading of South African ratings. The local currency credit rating was demoted from BB+ to BBB-, sending the Rand sliding. However, the currency rallied after Moody’s decision to place the country on review for downgrade. Despite the fact that this still presents a negative outlook for the future of the South African economy, the fact that Moody’s did not actually downgrade the country at the same time as the S&P has been seen as a positive. The country will be under review for a 90-day period before a decision is made on its rating. Following the decision from the S&P, Zuma directed his Finance Minister to identify various concrete measures which could be used to address the economic challenges facing South Africa.

The future is not looking positive for the South African economy. In September, the World Bank cut the growth outlook for 2017 to 0.6% from their previous estimate of 1.1%. Although the estimates for the next few years are slightly more positive, 1.1% and 1.7% in 2018 and 2019 respectively, this would be a poor performance for any economy, let alone a developing one such as South Africa.

South Africa has experienced weak economic growth and high unemployment which has led to a huge amount of poverty in the region. Unemployment has also dampened growth in the consumer sectors. These are not the only reasons for the downgrade, however. The country is also experiencing political and budgetary issues. President Zuma could potentially come under the same problems that Mugabe suffered recently in Zimbabwe. Mugabe’s attempt to put his wife in power was not popular and led to the soft coup, culminating in his resignation. Zuma is pursuing a similar idea and is trying to ease the way for his ex-wife to take power in the 2019 elections. However, the potential for military intervention is a lot lower than in Zimbabwe, and so it would be much harder to settle the dispute. One of the main points that South Africa can learn from Zimbabwe is that disputes are resolved much more easily within the ruling parties than out on the streets.

South Africa has not had a huge amount of luck in recent times. They have attempted to gain a major sporting event in an attempt to boost economic growth. However, they have had numerous setbacks over the years, with failed bids for the 2011, 2015 and 2019 Rugby World Cups. They recently failed to gain the 2023 Rugby World Cup as well suggesting the sport is becoming more and more dominated by money, especially due to the fact that South Africa was initially named as the favourite to host the event in 2023. This has just added to South Africa’s economic woes.

Zuma must now be extremely careful when making plans to deal with the dire economic situation. The country has had a lucky escape with Moody’s decision to only place the country under review. A downgrade from Moody’s could lead to South Africa falling out of the Citi World Global Aggregate Bond Index. This would lead to further outflows from the bond market. Therefore, Zuma’s next steps have the potential to either raise the country to new heights or lead to deeper economic problems. However, Zuma focuses on staying in power rather than using his power to the country’s advantage. Therefore, there could be a need for change in South Africa to prevent further problems down the line.

South Africa’s shaky economy – the power of rating agencies demonstrated

Oliver Dyson

South Africa’s economic outlook looks dire for the coming months. On October 25th, Malusi Gigaba -South Africa’s Finance Minister – revised GDP growth estimates down from 1.3% to 0.7% in the Medium-Term Budget Policy Statement (MTBPS), firmly placing the nation as the third worst-growing economy, behind Brazil and Switzerland. This is not a developing market issue; South Africa is not following the current trend rate of growth in emerging markets, currently standing at around 3.4%. Unemployment rates of 28% also pose an issue on how to improve government finances in a situation where next year’s budget deficit is forecast to stand at 4.3% of GDP. More troubling are the recent S&P downgrades of Rand-denominated bonds to ‘junk’ grades which has worsened the options for South Africa going forward.

Slack demand for the country’s exports, along with political turmoil have culminated in an economic recession over the past few quarters, ending in September of this year. Investor confidence has remained low in the nation, spurred by several scandals involving President Jacob Zuma. The first family’s close involvement with the Gupta family, a cohort of rich Delhi-born businessmen, has created anti-corruption outcry with many suggesting that the family has been using their influence to achieve policy changes. Indeed, the anti-corruption minded former Finance minister Pravin Gordhan was one of the largest critics of the family, stating that the Guptas had bee involved in ‘suspicious’ transactions worth some $490m. Several downgrades by rating agencies were unsurprisingly made when pro-reform Gordhan was ousted by the ruling party. Zuma’s African National Congress (ANC) party has been under increasingly close scrutiny going forward; investor trust has suffered as a result.

Zuma’s economic policies going forward are also giving cause for concern in markets. The President told his Presidential Fiscal Committee to reduce spending by 25 billion rand ($1.8 billion) in next year’s budget and to find ways to add 15 billion rand to the nation’s revenue. This is likely to lead to tax increases, which may dampen economic expansion for a country that just exited its second recession in a decade. Ratings agencies have severely downgraded their outlook for the economy as well; S&P stated last week that “South Africa’s economy has stagnated and external competitiveness has eroded”. The institution downgraded Rand-denominated debt to one-level below investment grade at BB-, with Fitch following suit. This move has contributed to the nation’s economic woes by ensuring that SA bonds have been expelled from the Barclays Capital Global Aggregate Bond Index (which only trades S&P investment-grade bonds). With access to $2tn of capital now cut off, the government’s borrowing costs are set to rise, as a rise in issued debt is expected in the near future to plug the deficit gap. As evidence of this issue, yields on 10-year bonds have increased from 8.4% to 9.4% since October, reflecting investors’ waning confidence in the economic performance of the nation. The rand also fell by 2% after the announcement.

However, the rating agency Moody’s has decided to keep local-currency bonds on its rating of Baa3 (the lowest investment-grade rung above ‘junk’) for the next 90-days as it revises its decisions. This decision has enabled SA bonds to remain in the Citi World Government Bond Index (with access to a much larger $8tn of foreign capital), while Citigroup economist Gina Schoeman has estimated outflows of 100 billion rand ($7 billion) from the bonds if they are allowed to fall to ‘junk’ grade. Clearly, the government has been thrown a lifeline from Moody’s decision, which has given it the opportunity to turn the economy around in the next 90 days. Indeed, this took the rand’s year-to-date carry return against the dollar to 5.7 percent (up from a negative rate in early November), meaning more investors performed carry trades (borrowing in rand to buy more dollars) following this announcement. Reinforcing the gravity of this decision, previous Finance Minister Gordhan stated that if Moody’s downgrades the country to sub-investment grade, it could take up to 10 years to recover.

Going forward, both ratings agencies and investors will be looking at the ANC party conference in December, which will pick Zuma’s successor. Many argue that the role is only truly contested between Zuma’s ex-wife Nkosazana Dlamini-Zuma, who argues for a more equitable distribution of wealth in the economy, and Cyril Ramaphosa arguing for reigniting growth and restoring investor confidence. Investors may have several opportunities present with this conference. Firstly, prices of options for dollar-rand volatility remain around the highest in a year for one-month contracts. That suggests that traders are anticipating big market swings when the ANC decides who will replace Zuma as party leader. Moreover, Toronto-based bank Toronto-Dominion says the Rand may rally by almost 10 percent to 12.55 next year if Ramaphosa or another candidate outside Zuma’s faction wins the vote, especially if they push the president to resign from his role of as head of state before the end of his term in 2019. This would be a great improvement for the economic outlook of South Africa, as growth-based policies would be put in place once more. This party conference on 16th -20th December should therefore be watched closely by FOREX traders.

Yet it is hard not to forget about the fundamentals of the economy. The same issues of low growth, large inequalities, high unemployment and low investment still remain and it is unlikely that these will be resolved soon. Low growth and poor credit/bond ratings may be here to stay for Africa’s largest economy, which is why a favourable Moody’s rating on rand-bonds in the next few months is vital to lifting the economy out of a low-confidence malaise.