Inflation Fears Prompt Policy Shift
Surging inflation driven by sharp increases in food costs is clearly a concern for officials in Beijing, who are sensitive to the potential for inflation to trigger an escalation of already worrisome levels of domestic social unrest. Sharp increases in the cost of food and fuel have an especially pronounced negative impact on the budgets of low-income households, and Communist Party leaders are justifiably worried that persistent high inflation could fuel the spread of rural unrest and labor disputes, both of which have become increasingly common in recent years.
The central bank has responded by hiking interest rates, and an official change in the government’s monetary stance was confirmed at a policy meeting attended by President Hu Jintao and Premier Wen Jiabao in December. In a New Year’s address, Zhou Xiaochuan, the central bank governor, pledged to hold inflation in check through the use of counter-cyclical policy tools, to include the imposition of higher reserve requirements on “systemically important” banks. The government has set an inflation target of 4% for 2011, and the central bank is expected to raise the interest rate two more times by the middle of the year.
While monetary policy will remain the most important tool in combating inflation, allowing the yuan to appreciate at a faster rate would also help to dampen price pressures by lowering the cost of imported goods. The currency appreciated 3.6% in 2010, and the markets are currently predicting a further rise of 2.7% this year. However, Li Daokui, a member of the central bank’s Advisory Committee has suggested that the yuan could appreciate by 5%–6% in 2011, which would not only help to combat inflation, but would also address the complaints of lawmakers in the US, where President Hu made a state visit in January.
Landslide Election Could Prove Costly
The ruling NDP won a landslide victory at legislative elections held in November–December 2010. On the surface, the outcome leaves the NDP in a remarkably strong position, which would seem to bode well for further progress on a program of liberal economic reforms advocated by Gamal Mubarak, the son of President Hosni Mubarak and the head of the governing party’s powerful Policies Committee.
Unfortunately, a more ominous outlook is taking shape just below the surface. Denied any legitimate avenue for pursuing their political aims, and disgusted with the inability of the official opposition parties to work in concert, ordinary Egyptians may be drawn to more radical alternatives. The New Year’s Eve bombing of a Coptic church in Alexandria, purportedly by an extremist group with links to Al Qaeda, and the more recent toppling of Tunisia’s autocratic president further reinforce the negative outlook.
Such considerations will complicate the NDP’s task of choosing its presidential candidate for the election in September. Despite reports of support within the NDP for a change of leaders, the party brass might decide that a transition is too risky under current conditions. However, Mubarak’s continuation in power would give the opposition an issue around which to build a popular movement, and would heighten the risk of destabilizing tensions within the ruling party.
Despite the recent rise in political uncertainty, Gamal Mubarak has signaled that the government is prepared to move ahead with a fresh round of liberal economic reforms, with the aim of generating annual real GDP growth of 7%–8%, the minimum required to reduce poverty and ensure that job creation keeps pace with the expansion of the labor pool. Toward that end, he has proposed increasing investment in public services more than three-fold to $17.2 billion per year through the expanded use of public-private partnerships.
The Egyptian pound dropped to a six-year low against the dollar following the fall of the Tunisian government in mid-January 2011, but appears to have stabilized thanks to intervention by the central bank. Barring a significant deterioration in domestic stability, strong capital inflows and relatively high interest rates are expected to support the pound, limiting the risk of exchange-rate volatility in the near term. In any case, the central bank possesses the resources to engage in corrective intervention if political events that spook investors trigger a sharp drop in the value of the pound.
Prior to the fall of the Tunisian government, portfolio investment had proven to be relatively immune to negative political developments. The country’s main stock index rose by 20% over the second half of 2010, despite the tumult associated with the elections, and the rally revived following a brief retreat in the immediate aftermath of the New Year’s Eve bombing in Alexandria. However, the index fell by 8% in the wake of President Zine El Abidine Ben Ali’s flight from Tunisia, and a rebound could be jeopardized if the security forces mishandle pro-democracy demonstrations planned in Cairo and Alexandria on January 25.
Threat of Debt Crisis Looms Large
The country’s fiscal position took on a slightly more positive hue in late December, when the Parliament approved a 2011 budget that targets a reduction of the deficit from 9.3% of GDP in 2010 to just 6% this year, to be achieved through a combination of tax increases and spending cuts totaling about $160 billion. The government is counting on its austerity program to ease doubts about the ability of the central and regional governments—and their financial institutions—to continue meeting the massive debt obligations. Although the yield on the most recent bond issues was lower than the peak reached shortly after Ireland was forced to seek a bailout from the EU and the IMF in late November, it was still well above the very low levels that enabled Spain to finance a debt-fueled boom that came to a crashing halt in 2008.
Despite what appears to be slightly more promising news on the debt financing front, the cuts contained in the 2011 budget will only add to the troubles in the housing sector, the main engine of growth during the period of easy money. Adding to the gloomy outlook for the sector, monetary authorities have ordered banks to put aside additional reserves equivalent to 30% of their repossessed property holdings, which could force banks to shed their holdings of defaulted properties on a market with very little appetite for such assets.
That is bad news for Spain, which will become the main focus of nervous investors in the very likely event that Portugal is forced to follow Greece and Ireland in seeking an international bailout. Any setbacks in fiscal consolidation efforts will undermine confidence in Spain’s ability to finance its debt, widening the yield spread on Spanish bonds and forcing the government to seek its own bailout. The chief danger lies in the high potential for austerity measures to drive the economy into a downward spiral, resulting in a revenue shortfall that throws the entire fiscal consolidation program into doubt. In that event, it is unlikely that the markets will be reassured by anything less than a decisive move by the euro zone to put an end to the uncertainty.
Current Account Deficit, Inflation Pose Risks
In September 2010, Turkish voters approved 26 amendments aimed at bringing the country’s constitution into compliance with EU standards. The most significant changes increase the government’s control over the military and the judiciary. The vote was closely watched as an indicator of support for the ruling AKP, which faces a test of its mandate at a general election in mid-2011. The main opposition CHP strongly opposed the changes, and both the high turnout (officially put at 77%) and the 58% support for the changes appear to put the AKP is in a good position to win another term.
That prospect will cheer investors, who have noted the substantial strides the AKP government has made toward putting the economy on a stable footing during its decade in power, and responded by pouring investment into the country. Although the global downturn contributed to a significant fall in levels of foreign direct investment, which averaged more than $20 billion per year during 2006–2008, flows of short-term investment have made a rapid recovery.
However, the steep rise in the local stock market index has stirred fears of potential asset bubbles. Even more worrisome is Turkey’s growing reliance on short-term capital flows to finance its rapidly expanding current account deficit, which has left Turkey vulnerable to a balance-of-payments crisis in the event of a negative shift in sentiment. The flood of foreign capital has also contributed to a significant appreciation of the lira, reinforcing concerns about the size of the current account deficit, which ballooned to an estimated 6.4% of GDP in 2010. Officials are keen to avoid imposing capital controls, and will instead rely on low interest rates to discourage short-term investment, but more traditional means of stemming inflows of hot money may be necessary if the tightening of reserve requirements for banks fails to hold inflation in check.
Cooperative Spirit Lacking
The governing Democratic Party suffered a historic defeat at mid-term congressional elections in November 2010, as the opposition Republican Party (GOP) picked up 63 seats in the House of Representatives, wiping out the gains made by the Democrats in 2006 and 2008 (and then some), and returning the opposition party to majority status in the lower legislative chamber. The Republicans did not fare quite as well in the Senate, where the potential for a shift in party control was limited by the fact that only 37 of the 100 seats were contested. In the event, the GOP made a net gain of six seats, reducing the Democrats’ majority to just three seats.
In general, the early signs suggest that the current congressional term will be marked by gridlock, rather than constructive compromise. That in turn means that the government is unlikely to accomplish much in the way of implementing policies that address the clearly unsustainable debt burden or boost employment growth.
Nowhere is the risk of an electoral strategy based on intentional gridlock more apparent than in the emerging debate over whether to raise the US debt ceiling. The Republicans might seek to force President Barack Obama to accept spending cuts by initially voting down a measure to raise the debt ceiling, confident that they would be able to revisit the issue in time to avoid actual default. Unfortunately, such a vote would in all likelihood roil the markets, resulting in lasting damage that would not be repaired by a later move to raise the ceiling.
A combination of currency appreciation, modest fiscal tightening, high unemployment, and the continued weakness of the housing market will reinforce disinflationary pressures in 2011, pushing the inflation rate down to 1.3% this year. There is no room for a further reduction of interest rates, and US Federal Reserve Board Chairman Ben Bernanke has indicated that he is prepared to implement additional rounds of quantitative easing if necessary to stave off deflation. In any case, there is little chance that monetary authorities will initiate a tightening cycle at any point in 2011.
As such, the yield on bonds will remain well below the earnings potential for stocks, a prospect that is already encouraging a shift from bonds to equities that pushed the main US stock index up by roughly 15% over the last four months of 2010. The gains roughly coincided with Bernanke’s announcement of plans for a second round of quantitative easing in the final quarter of the year, and the prospect of further moves to boost liquidity, and reduced interest in commodities as China implements tightening measures, will strengthen the bias in favor of equities.
Banda’s Hopes Rest on Opposition Split
President Rupiah Banda has failed to translate the strong performance of the economy into an increase in his popular support, in part owing to widespread perceptions that he is too tolerant of corruption among his political allies. Even so, the failure of the opposition alliance forged by the PF and the UPND to decide on its presidential candidate or even to present a joint political program points to internal disagreements that have raised doubts about the survival of the partnership.
As long as Banda displays political astuteness in dividing the spoils of victory, the MMD can be expected to hold together and provide the basis for a legislative majority throughout the 18-month forecast period. However, factional rivalries will come to the fore as Banda’s would-be successors start jockeying for position, a process that is likely to begin well before the next election falls due in 2016.
Investment policy is for the most part guided by the recognition that economic diversification is essential to reducing the country’s dependence on copper revenues and creating the jobs required to reduce a very high unemployment rate. Foreign investment is acknowledged to be a vital component of that effort, a fact that will discourage any tightening of restrictions on equity, foreign exchange, or repatriation.
A strong recovery in copper prices has generated pressure on the government to reintroduce a windfall profits tax. However, even PF leader Sata went on record as opposing such a move, and the government announced the conclusion of an agreement with mining investors in late 2010 that will extend the existing tax arrangement for at least another 10 years.
The government has set a target of holding domestic borrowing to no more than 1.4% of GDP in order to avoid crowding out private investment, and donor support is budgeted to fall by nearly one-half this year, owing to the suspension of aid flows over transparency concerns. On that basis, financing the government’s expansionary fiscal strategy will require the assumption of substantial new foreign debt in the coming year. In the regard, the government enjoys a substantial margin for error, thanks to debt relief obtained under the HIPC initiative, and debt levels are expected to remain comfortably low.