SMU Political-Economic Exchange

AN SMU ECONOMICS INTELLIGENCE CLUB PRODUCTION

ISSUE 13 26 March 2012

- Is Chinas Economy Slowing Down? - Basel III: Its Provisions and Its Impact on the Financial World - Nobody Wins, Somebody Loses
The Fortnight In Brief (13 March to 26 March )

US: Slowly but surely The February employment report showed continued momentum in job creation. Private payroll growth and hours worked continued to rise. The labor market turnaround is clearly significant, which may play a crucial role to the presidential elections this year. Although shocks from oil prices remain a risk, the labor market suggests an improved macroeconomic environment. Meanwhile, manufacturing and retail data pose stronger readings, indicating that the US is slowly picking itself up from the recession. The index for Small Business Optimism edged up a mild 0.4 point to reach 94.3 in February. Though a sixth consecutive gain in optimism, sentiments are still at depressed levels. Asia Pacific ex-Japan: China in the hot seat Spurred by hiking oil prices, gasoline and diesel price in China rose by 7% and 7.8%. Despite its recent attempt to quell inflation in real estate market, residential property prices fell in 45 out of the 70 cities tracked, down from 47 in January and 52 in December. Flash estimates pointed to contraction in the manufacturing sector, falling to 48.1 from Februarys 49.6. The contraction is accompanied by a slowdown in employment as levels tanked to levels not seen since March 2009. To encourage lending in rural areas, PBoC cut the required reserve ratio (RRR) of an additional 379 outlets of Agricultural Bank of China, a move that could potentially inject 23 billion RMB into the system. While inflation in Hong Kong eases on lower food and housing prices, unemployment hiked to 3.4% (for 3-month period ending February), up by 0.2% from the previous period.

IN COLLABORATION WITH

EU: British Budget Proposes Tax Cuts For Businesses While this years proposed budget did not see big changes, several incremental tax reforms are proposed to help businesses cope with the global economic slowdown. The Government proposed a contentious tax cut on top earners from 50% to 45% to woo investors while corporate taxes will also fall to 22% by 2015, which is very low by G8 standards. These tax cuts are expected to be offset by rises on stamp duty on sales of expensive homes, as well as the introduction of a capital gains tax on such properties. Tax allowances for pensioners and child benefits are also being tightened to offset lower taxes.

PROUDLY SUPPORTED BY

Is Chinas Economy Slowing Down?

By Lin Liye, Singapore Management University This article looks at the factors that might indicate a slowdown in Chinas economy. I recall a scene in Beijing when I visited last December on an overseas community service trip (OCSP). As my bus drove past a development site, rows of unfinished condominiums stood in the bitter cold, amid empty roads and walkways. Like many other cities in China, Beijing had witnessed blistering growth in the property market. But while property prices were rapidly rising to historical highs, many apartment buildings remained vacant, possibly due to over- speculation in the market. Many economists began to argue that China had overinvested in its economy and that a property bubble was forming, as shown in Fig 1, which could bring the economy to a hard landing when it bursts. This analogy is only a simplification of Chinas economy, currently the second largest in the world, but it is a warning sign that Chinas economy may not be as healthy as official GDP growth statistics show it to be.

Fig 1: Land Price Index for Beijing Source: atans1.wordpress.com

Several key economic indicators1 have indicated that Chinas throttling growth might be slowing down after all. The growth rate of real GDP per capita of China is likely to hit 7.5% this year by the government, a fall from double-digit rates in the past decade. While upper middle-income countries like China are expected to enjoy lower rates of growth as they become richer, the size of Chinas economy means that its slower growth will affect the global economy. With the western economies slowly beginning to recover from the Great Recession, weaker growth in China may affect export demands in those economies and slow down their economic recoveries as well. Even in Australia, which has weathered the 2008 recession well 2 Copyright 2012 SMU Economics Intelligence Club

and now sends over 26% of its exports to China alone, a sharp fall in these exports will bring Australia into a deep recession. Chinas central bank, the Peoples Bank of China (PBOC), has also lowered the reserve requirement ratio2 (RRR) several times since November 2011, including another 0.5% reduction on 24 Feb this year. By adjusting the RRR, the central bank is able to control the money supply in the economy without adjusting the nominal interest rate. When there is a danger of the economy slipping into recession, the central bank will want to increase the money supply to boost consumption and investments. This will boost GDP growth and reduce the chances of the economy falling into a recession. One reason for lowering the RRR could be to prevent a possible credit crunch3. It was disclosed that local governments in china had accumulated almost 11 trillion yuan in debt. This figure, which was not included in the official central government debt, understated the health of the local governments financials. Most of the money was spent during the 2008 fiscal stimulus in infrastructures and investments, and governments had not recouped the amounts invested yet. This leads to the local governments difficulty in refinancing the debts, as they do not have any solid plans on how to repay the debts.

Fig 2: Reserve Requirement Ratio in China Source: Centralbanknews

Facing difficulties in sustaining a high growth rate, the government is slowly shifting the focus of the economy from export-oriented to consumption-oriented. Unlike Singapore, which also depends heavily on exports, China is too big an economy to sustain its growth solely on exports. Ultimately, there is a limit to how much other countries can buy goods that are made in China. Hence, it is important to encourage domestic consumption as a future engine of growth. Currently, only 35% of Chinas GDP is driven by consumption, compared to an average of about 55% in the OECD countries, which means there is huge potential for growth 3 Copyright 2012 SMU Economics Intelligence Club

in Chinas domestic market. By shifting the focus of the economy to domestic consumption, China will be more shielded from external shocks to the global economy. Additionally, GDP growth will be more inclusive because workers enjoy higher standards of living through more consumption. The most obvious way of boosting domestic consumption is raising the wages of workers, which, unsurprisingly, has risen by more than 21% last year. However, this nationwide increase in wages has led to increased labor costs for companies. Many foreign firms came to China to take advantage of readily available cheap labor, but rapidly rising wages have led firms to consider relocating to regional industrial bases like Vietnam or Bangladesh. In the short-run, this is unlikely to happen because China possesses vastly superior infrastructure and it remains easier to obtain supplies here than, say, Bangladesh. In any case, China is unlikely to maintain its double-digit growth rate indefinitely, but its economy will continue to be scrutinized as it continues its march to be the worlds largest economy. Economic Indicators allow analysis of economic performance and predictions of future performance.
1

2 Reserve Requirement Ratio (RRR) is a central bank regulation that sets the minimum reserves

each commercial bank must hold of customer deposits and notes. It is normally in the form of cash held in the bank vault or deposits made with the central bank. 3 A credit crunch is a sudden tightening of the requirements to obtain a loan from banks, which reduces credit available in the entire economy.

Sources: The Economist, Financial Times, Wall Street Journal, Centralbanknews, atans1.wordpress.com

4 Copyright 2012 SMU Economics Intelligence Club

Basel III: Its Provisions and Its Impact on the Financial World
By Gabriel Tan, Boston University For those of you who have not heard of Basel 1 or 2, do not fret. This article does not require a substantial knowledge of Basel IIIs predecessors. In short, Basel 1 was a meeting of central bankers from around the globe in 1988 in Basel, Switzerland. This meeting gave birth to international requirements for banks to adhere to a minimum ratio of capital to risk-adjusted assets. The need for such a ratio is quite fundamental. A banks risky assets could cause serious concerns and being over leveraged in the event that these assets started defaulting would lead to a financial crisis very similar to that of 2008. According to the Basel requirements, a banks assets are given weights from 0% to 100% in terms of how risky there are. There is no true scientific method to calculate these weights but instead the committee used their best judgment to give riskier assets higher weights. A banks capital such as common stock and retained earnings are then viewed as a percent of the total risk-weighted asset pool. The banks capital is also split into several tiers of quality and this will be touched upon later. With this in mind, we can discuss what Basel 2 and the new set of requirements instated in Basel 3 and whether or not these requirements will be adequate to reach their goals. Basel 2 reformed Basel 1 in its best efforts but not all its reforms were for the best. In addition, several serious issues existed within Basel 2 that no one saw before the crisis. Firstly, Basel 2 lowered the capital requirements from Basel 1. Secondly, in efforts to assign weights to the risk-adjusted assets, Basel 2 utilized major rating agencies1 such as Moodys to do so. We saw the lack of credibility in the rating agency system during the last crisis when so many mortgage-backed securities2 were erroneously ranked as virtually risk free. Thirdly, Basel 2 allowed the largest banks to use their internal measures of risk to deem their own risk weights. This method of risk measurement is inherently flawed. There is clearly a conflict of interest in the risk measurement as well as a lack of objectivity. The last two problems with Basel 2 became apparent only after the crisis. Firstly, structured investment vehicles3 (a major contributor to the mortgage crisis) allowed banks to shift a lot of risky assets off their balance sheets to meet the capital requirements. Secondly, the crisis highlighted the importance of liquidity and capital requirements did not address this need. Basel 3 was created to address all of these problems and more. The new guidelines will require banks to increase their capital ratios and tightened the guidelines of common equity to 7% of assets. The new guidelines also introduced a simple and elegant solution to the problem of risk weighting. It created a minimum requirement for a Tier 1 capital to total assets ratio without any weighting. However, due to the lack of weighting, the ratio had to be low, around 3%, which in reality is not a solid benchmark at all. Basel 3 also managed to bring structured investment vehicles back onto the balance sheets of banks for the overall leverage ratio (without risk weighting) but not for the more refined ratios involving risk weighting. The new guidelines also created a standard for liquidity in banks such as the liquidity coverage ratio that will give a bank enough liquidity to endure a 30-day stressed funding scenario. With all that being said, Basel 3 has still failed to take several important issues into account. The new guidelines do not address the issues of rating agencies playing a major role in the weighting of risky assets nor do they prevent the major banks from using their internal models to measure their own risk levels. 5 Copyright 2012 SMU Economics Intelligence Club

 With these new guidelines in place we should see a serious impact across the globes financial systems. The increase in capital requirements is fundamentally going to decrease banks return on equity and thus banks have to react to this. The increase in such standards is undoubtedly going to be difficult for banks to close in upon and doing so will negatively affect their profits. Although banks have until 2019 to meet some of the requirements, the measurement of these ratios and changing capital standards takes lengthy periods of time and negative hits to profits. In terms of a more macroeconomic view, a forced holding of increased capital will cause banks to increase their lending interest rates to combat their increased cost of capital. This could negatively affect GDP as interest rates rise and consumers then become less willing to borrow and spend. This of course assumes that there is no government intervention to spur the economy and reduce interest rates. Overall, the new guidelines of Basel 3 have rectified more problems than it has missed or even created. As with all change, there will be periods of uncertainty and drops in efficiency. However, the long run benefits of ensuring the monetary soundness of banks is worth the effort.
A company that rates an entitys ability to pay back a loan. The rating given by such an agency

is important because it affects the perceived risk element incorporated into interest rates that are applied to loans. 2 A bond which cash flows are backed by homeowners' mortgage payments. 3 A pool of investments that buys long term bonds and other fixed income securities, and funding it by issuing short or medium term debt such as commercial paper. Sources: Wall Street Journal, Bank of International Settlement, McKinsey, Economist

6 Copyright 2012 SMU Economics Intelligence Club

Nobody Wins, Somebody Loses

By Brendan Chua, Singapore Management University As Greeces life support continues, I thought it was fitting to turn our attention towards a multilateral conflict of comparable gravity - the escalating tensions between the West and Iran. First, a brief background. EU leaders have successfully coordinated an embargo1 on Iranian oil as Iran refuses to back down on its nuclear programme. The US has also imposed sanctions2 on the Iranian central bank to prevent Iran from receiving payments for its oil. In response to these tighter sanctions, Iran threatens to block the Strait of Hormuz, through which one-sixth of the worlds oil and large amounts of natural gas liquids pass. Iran further threatened to cut off oil supplies to six European countries consisting France, Greece, Italy, the Netherlands, Portugal and Spain. Bilateral tensions between Iran and the U.S. will potentially be reminiscent of a boxing match, each raining blows on the other, eventually leaving both economies battered and drained. That said, Iran knows that the cost of sanctions will wear its economy down before the U.S. shows any signs of letting up. Predictably, Iran has been throwing several half-hearted punches in an attempt to buy time on the ring. The U.S. has also taken cautious manoeuvres, reciprocating a prod-and-check approach. This episode may turn out to be a drawn-out conflict, to the detriment of both nations and the global economy. What the US is trying to avoid Iran is the second largest OPEC3 producer, exporting 3.55 million b/d, representing 11% of OPECs total. Coupled with Irans naval deployments in the Gulf, it is estimated that the country has the capacity to disrupt 42% of global oil trade. Further, oil supplies are estimated to cut by 15 million b/d and oil prices may soar above the $140 mark should uncertainty spark panic. While it is hard to imagine Iran enforcing its threat, the U.S. and EU will be hard- pressed to avoid the economic consequences of a shut down in the Strait of Hormuz. The U.S. will be severely affected by soaring oil prices given its oil guzzling consumption in vehicles and manufacturing plants, higher import reliance and lower oil taxes. On the other hand, lower energy imports resulting from declining consumption in Europe should leave the region more insulated from a spike in oil prices. However, the global economy will still be hit hard by hefty inflation as manufacturing output drops while rising oil prices weigh in on the consumer dollar. The Game of Prod-&-Check Therefore, the U.S. will continue to take a measured approach against Iran to prevent oil supplies from tightening too abruptly. The U.S. and EU have agreed on progressive trade sanctions, with effect from the beginning of July, to allow countries to find alternative sources of energy. Obama may also be pressured to grant waivers to exclude some EU nations from trade sanctions if it is in the US interest to keep prices down. This conundrum will ensue in the coming months. The world will count on the US to make a reassessment of Irans capacity and probability of retaliation with each tightening of the noose. 7 Copyright 2012 SMU Economics Intelligence Club

Israel is already urging the US to take a more aggressive approach towards Iran, including launching military action against Irans nuclear sites. However, Republicans will surely tap on voters anger towards any rise in oil prices, or worse, the possibility of US entering yet another era of warfare. Even if the US military has an upper hand against Irans, one can expect Obamas near term rhetoric to remain unchanged: give sanctions a chance to work. Certainly, the U.S. is not alone in its measured play. Irans decision to halt sales to France and UK provides more bark than bite since neither country imports much oil from Iran. Iran has also announced a number of advances for its nuclear program, including a 50% increase in uranium enrichment capacity, production of new centrifuges, and the loading of domestically produced fuel into a research reactor to further instigate the West. From Irans perspective, there is always a sliver of hope that the West will back down if it deems the threat from Iran to be credible enough. Iran will therefore continue deploying scare tactics, if only to remind the West of the high stakes involved. Oil Prices Threaten To Stay Up The long drawn-out rattling from both sides means that oil prices will continue to carry a heavy risk premium. Brent crude prices are estimated to stay within the range of $110 - $140 as we draw closer to July, when more sanctions take effect. The price of Brent Crude has already risen sharply in the recent month. However, a long drawn-out conflict which keeps oil prices high seems to put a greater strain on the West compared to an extremist response from Iran. Although blocking the Strait would certainly lead to an immediate price surge beyond $150 levels, this should have a relatively shorter term impact considering an immediate military response from the West to free up the channel. Iran has tried to play up the fear that cornering the oil rich nation is tantamount to economic suicide for the West. However, the chess play does not reaffirm the claim. If Iran simply halts its exports, the world can still count on countries like Saudi Arabia, Abu Dhabi, Qatar, Kuwait, Iraq and Bahrain to export oil and gas by tanker through the strait. Such a move would only help the Arab neighbours profit from higher oil prices. Therefore, the only real threat stems from a total shutdown of the Strait by Iran, disrupting the oil trade of its neighbours. As oil prices surge, global demand plunges and no country would imaginably be better off or sympathetic towards Irans pursuit. For Iran, turning its back against the world would illicit tighter sanctions and a severe strain on the military front, crippling Irans economy. The Economy Bleeds

Source: Financial Times

8 Copyright 2012 SMU Economics Intelligence Club

 Time is running out for Iran Iran finds itself in a conundrum; as much as it tries to buy time to hasten its nuclear programme, its economy will be strained significantly over time as sanctions and the trade embargo gains traction. Major Asian imports of Iranian oil are already declining: China recently announced cuts to its growth target, signaling lower oil consumption which has historically been proportional to income; Indias biggest consumer of Iranian oil, Mangalore Refinery and Petrochemicals Ltd, plans to cut its annual import deal with Tehran by as much as 44% to 80,000 barrels per day in 2012/13; Japan and the United States are close to an agreement on cuts in Japanese imports of Iranian oil that will allow Tokyo to avoid U.S. sanctions, and may conclude a deal in March. Additionally, EU leaders have frozen the assets of Irans central bank, cutting off Irans most powerful vehicle to transfer funds electronically to smother its nuclear programme and stifle transactions from its oil trade. While Iran has the capacity to disrupt oil prices, it seems that a sustained shutdown of the Strait is unlikely. As July looms, countries should set up alternative trade agreements to buffer any disruption in oil supplies. Meanwhile, Iran will be increasingly isolated by global sanctions. While this conflict will not leave any country unscathed, it is difficult to envision how Iran can outlast the rest of the world in its nuclear pursuit. The white flag may be raised sooner rather than later.
1 Partial or complete prohibition of commerce and trade with a country, in order to isolate it.

2 Trade penalties imposed by a country or group of countries on another country. These may

take the form of import tariffs, licensing schemes or administrative hurdles. 3 Organisation of Petroleum Exporting Countries. An intergovernmental organization of 12 oil- producing countries which has a wide influence on oil production and prices. Sources: Financial Times: Micro-lending and the battle against world poverty, BBC.

9 Copyright 2012 SMU Economics Intelligence Club

 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 (Vice President, Publication) changxun.ai.2010@smu.edu.sg Singapore Management University Singapore Kwan Yu Wen (Vice President, Operations) ywkwan.2010@smu.edu.sg Singapore Management University Singapore Herman Cheong (Marketing Director) Wq.cheong.2011@smu.edu.sg Singapore Management University Singapore Randy Lai (Editor) Tw.lai.2010@smu.edu.sg Singapore Management University Singapore Lin Liye Liye.lin.2011@smu.edu.sg Singapore Management University Singapore Brendan Chua Brendanchua.2009@economics.smu.edu.sg Singapore Management University Singapore

Ben Lim (Vice President, Publication) ben.lim.2010@smu.edu.sg Singapore Management University Singapore Tan Jia Ming (Publications Director) jiaming.tan.2010@smu.edu.sg Singapore Management University Singapore Vera Soh (Liaison Officer/Writer) Vera.soh.2011@economics.smu.edu.sg Singapore Management University Singapore Seumas Yeo (Editor) Seumas.yeo.2010@smu.edu.sg Singapore Management University Singapore Gabriel Tan gtan@bu.edu Boston University United States of America

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.

10 Copyright 2012 SMU Economics Intelligence Club