Last week’s Economist had a couple of nice articles on China’s National Day on October 1st, when the Chinese showcased their military, including the DF-31 nuclear-tipped ICBM, which can hit any city in America.  Most of these armaments have “Made in China” tags, not unlike all of our clothes and toys.

The Economist leader on the subject lamented this show of militarism, even comparing modern-day China to Prussia/Germany and Japan in the late 19th century.  I recall attending Bastille Day celebrations along the Champs Elysee in Paris in years past, when the glory-obsessed French showcased their military hardware; yet nobody got bent out of shape about French militarism.

Yet the rise of China should rightfully be compared to the rise of powers-past, such as Germany, Japan, Russia and the U.S.  We should consider how status-quo powers such as Britain might have mismanaged some of these rises in the 19th century and how we might avoid such mismanagement with regard to China today.  The blame for German militarism rests largely on the shoulders of Germans, this is true, especially on the fragile shoulders of Kaiser Wilhelm II and his cabal (though even Bismarck shares some of the blame).  Even so, the Western Powers could have better managed Germany’s rise.  They lacked an agenda for providing Wilhelmine Germany with enhanced international privileges to match its rising power.  Matching privileges with power is key to peacefully managing a power’s rise.  And, anchoring a rising power in the institutions of the status quo is likewise critical.

With the Concert of Europe and the Congress system of Metternich dead by the late 19th century, there were no international institutions to anchor Germany.  China, by contrast, is a card-carrying member of the U.N. Security Council, the WTO, the IMF and World Bank, the G-20, G-2, and other institutions.  Furthermore, although China may still feel somewhat dissatisfied because Taiwan and other East Asian assets (such as oil reserves in the South China Sea) are not being handed to it on a silver platter, Chinese privileges in the world are being equated step-by-step with Chinese power.  The ”peaceful rise” of the dragon is taking place, at least in part thanks to Western statecraft.

The parallel with Wilhelmine Germany is a nice one, but on one key parameter, China falls short of authoritarian Germany.  Germany of that era was a pluralist, if not a liberal, society.  There was the Reichstag, in which the Social Democratic opposition was well represented.  Sure, the Kaiser and his ministers were not beholden to the German parliament.  Yet the nascent democratic institutions were there, whereas Chinese communism has not provided such vehicles for democratic development.  Likewise, Bismarck had provided Germany of those days with the most progressive social security safety net in Europe, neutralizing in part the appeal of the left.  In China’s Workers’ Paradise, the social safety net is woefully inadequate.

A few months ago, observers worried that the global financial crisis could weaken the Chinese Communist Party’s hold on power.  As long as the CCP delivered economic growth north of 8% a year, few questions were asked by the populace.  But this social contract was seen as at risk.  These days, observers are applauding the resilience of the Chinese economy at weathering the storm.  However, China’s recovery has been driven by a huge fiscal stimulus and a massive state-directed lending boom, which could lead to banking sector weakness in the future.  True, China is much less-leveraged than the US or almost any Western nation, so it has room to be a little profligate.  Nevertheless, an economic shock in China, followed by political turmoil, cannot be ruled out.  Note that China’s leaders told Beijingers earlier this month to stay home in their crowded apartments to watch the National Day Parade on television, instead of thronging over to the Forbidden City, which couldn’t have a more suggestive name.  Since 1989, popular protests are the nightmare of China’s leaders.

Sovereign risk in Turkey was once talked about in the same breath as Brazil’s.  Not so anymore.  One is going hat in hand to the IMF, likely to get $45 billion in the coming weeks; the other is largely self-financing.  What went wrong in Turkey?  Always keep your eye on the current account deficit, folks, even when Wall St. analysts tell you its nothing to worry about because it’s financed by FDI, or some such Bernanke-esque bunk.  Current account deficits mean borrowing from abroad.  And that means vulnerability.  Turkey went into the global crisis with a 5-6% current account deficit, while Brazil went in with small surpluses.  Keep your eye on America as well and its sovereign credit risk — current account deficits there have been nearly halved to 2-3% from 5-7% a couple of years ago, largely due to the US recession.  But the U.S. still can’t kick its foreign borrowing habit, Obama’s protectionism notwithstanding.  Likewise, watch out for “twin deficits.”  That’s when government deficits move in tandem with current account deficits (the former often driving the latter).  The US has these, as does Turkey (where government deficits are in the range of 5-7% of GDP, versus Brazil’s 3-4%).  Turkey’s overall government debt burden remains modest at under 50%, versus Brazil’s near-70%; however, Brazil’s government debt burden is headed down, while Turkey’s is rising.  Hence, Fitch moved Brazil up to investment grade not long ago, while Turkey languishes at BB-.  They both were BB- only a few years ago.  Sometimes the rating agencies get it right, even though it often takes them some time to do so.

So, the Turkish prime minister shows up hat in hand at the IMF’s doorstep, while President Lula’s Brazil is considered a rising power.  Have a look below at the CreditSuisse report from today on Turkey’s negotiations with the IMF.  Deputy Prime Minister Babacan, whom I met with in the past and perceive as smart and wily, is thankfully in charge of these negotations.

From CreditSuisse:

Turkey
Berna Bayazitoglu
+44 20 7883 3431
berna.bayazitoglu@credit-suisse.com
Prime Minister Erdogan denounced yesterday the claims in the local media that the IMF has offered a sizable financing package to the Turkish government which it cannot turn down. As we reported in the Emerging Markets Economics Daily yesterday, Erdogan told the Wall Street Journal on Monday (5 October) that the Turkish government has resolved one of the sticking points with the IMF, namely the IMF’s request for an independent tax revenue administration, and added that “he would like to see a new IMF program for Turkey agreed soon.” This was the most upbeat assessment that Erdogan has offered on the subject in a long while. Looking for an explanation for the change in Erdogan’s tone about an IMF agreement, the Turkish media claimed yesterday morning that the IMF might have offered a large financing package to Turkey (amounting to $45bn) which Erdogan cannot turn down. However, at a reception later in the day, Erdogan denounced local media stories that the IMF has made a new offer to Turkey.

Nevertheless, Erdogan’s statements in the Wall Street Journal add strength to the possibility that the government might invite an IMF mission to Turkey soon. As we noted in the Emerging Markets Economics Daily yesterday, speaking at various conferences in the last few days at the IMF/World Bank annual meetings in Istanbul and somewhat in contradiction to Erdogan’s statements in the Wall Street Journal, Deputy Prime Minister Babacan (who is the senior policymaker in charge of policy discussions with the IMF) had said that the discussions on the tax revenue administration and local governments’ spending were still continuing and that the IMF was studying the government’s medium-term economic plan and fiscal program.

The Statistics Office will release the industrial production data for August tomorrow. We forecast that industrial production was down 4.7% yoy in August, slowing from a contraction of 9.1% yoy in July. Our forecast is more optimistic than the consensus forecast (according to Bloomberg) of a 5.2% yoy contraction.

 

An update on a post I did last week on the Obama administration’s swing toward trade protectionism with its action against Chinese tires:  enclosed is this nicely written NYTimes editorial…not an Op-ed, an editorial. 

The Times editorial board understands economics.  American workers in the tire industry, many represented by the United Steelworkers Union, may well lose their jobs with or without the new 35% tariff against Chinese tires.  The reality about trade, the Times points out, is that Americans will likely buy low-cost tires from other countries in any case, perhaps in Latin America, rather than from American factories.  These Latin tires will cost more than the Chinese variety, making American consumers worse off.

The Economist article I attached to the last post included a comment from an analyst suggesting that President Obama, by imposing these tariffs, is shoring up his left flank in order to achieve support for health care reform, that $900 billion budget-buster.  Maybe the linkage is far-fetched, but if true, putting at risk the global trading system in order to expand entitlements, is that what sound economies are built on? 

I hope the president deploys his considerable charm and intellect next week, talking things out with Chinese President Hu Jintao at the G-20 Summit in Pittsburgh in order to avoid a nasty trade war.  That venue would likewise be a fine place for the president to tell the truth to Rust Belt workers, the truth John McCain started telling in Michigan last year:  that the economy is in transition, we cannot artificially protect manufacturing jobs, job training and outplacement will be required.  The higher value-added, knowledge-based economy beckons…

During the Great Depression, international trade contracted by a third, as countries around the world erected barriers to trade, aggravating a sharp decline in output already under way and throwing millions out of work.  Thus far, in the Great Recession of 2008-09, the end of which some observers may have called too soon, the major powers have avoided trade protection.  Enter the Obama administration.

Last year, I published a piece calling for those supporting Democrats in America’s national elections to make sure they keep the Dems honest on trade.  Concerns about Obama’s commitment to free trade, due to his campaign strategy in Midwestern states last year, were dismissed as mere election-year politics.  His commitment to satisfying his friends in America’s trade unions is now abundantly clear, not only because he parrots their unfair accusations about abuses by the Colombian government, but also in the latest action by the Obama administration to raise tariffs against Chinese tires (see NYT imes article).

Trade wars can spiral out of control, even if this is not the original intention of protectionists.   During the 19th century, Britain, the unrivaled power at the time, ensured global prosperity through its commitment to free trade.  The U.S. since 1945 has played this role, through both Democratic and Republican administrations.  Doubts about President Obama’s commitment to free trade, a key pillar of international cooperation and a key strategy for broad-based global prosperity, have re-emerged, a point quite ably discussed in this Economist article.

Photo:  Chinese workers loading tires for export.  Source:  www.financialpost.com

It wasn’t Paul Kennedy who first said that great powers who over-extend themselves — either externally or internally — fast-forward the date of their decline, but he wrote about imperial over-extension and decline so convincingly in a best-selling book in the late 80’s.  Political Scientist Robert Gilpin in War and Change in World Politics argued that both internal and external over-extension overburdens a hegemonic power such as the U.S. and results in an early decline. 

A colleague on the Global Markets blog and other FPA bloggers have applauded President Obama’s economic policies for rescuing America and the world from an early demise.  The stimulus package was the right thing to do at the right time, I agree, as was the bank rescue, which began under Bush’s watch, spearheaded by Republicans Paulson and Bernanke as well as Democrat Geithner, a year ago, lest we forget.  I wrote about that on my blog, applauding all those involved on both sides of the aisle.  Yes, Paulson was helped along by Democrats Pelosi and Reid and brave Republican Mitch McConnell, whereas the rest of the Republican caucus abdicated all responsibility in the name of free market capitalism.  Like Lenin said, the last capitalist will sell the rope to hang the second-to-last capitalist.  I did hear, nonetheless, from not a few Democrats at that time who opposed the bank bailout, including some so-called New Democrats.

In any case, I applaud President Obama’s continuation of Paulson’s policies (and remember, these were policies backed wholeheartedly by the much-maligned George W. Bush). 

But why health care reform?  Okay, I know why health care reform.  But why now?  Why now, with U.S. General Government Debt set to reach nearly 100% of GDP within two years??!! 

The answer:  because Dems have majorities in Congress and they’re afraid they’ll miss this opportunity to extend entitlements.  The prudent thing to do — the thing leaders of a great power wishing to prolong its great power status would do — is:  tackle health care reform when (and if) the ship of state is not in hock.

An Economist article points out the fine job accomplished last night by the Great Communicator (II).  It also points out that President Obama put a figure on the cost last night — $900 billion, or 5-10% of GDP.  Obama in his speech committed to convening an independent panel of experts to find savings in Medicare and other health schemes and to putting in mandatory cuts if cost restraint doesn’t materialize.  Hats off to the president for including these two commitments in this expansion of the role of the state.  Nevertheless, to those of us worried about the decline of a great power so important to the liberal institutions of the world, this health care reform remains an awful lot of the farm to bet on the Great Communicator’s promises before a joint session of a Democratic Congress.

What would President Monroe say?

An Economist article discusses the growing presence of Great Powers, especially China, in Latin America, flouting nearly two centuries of U.S. dominance in the region, since the articulation of the Monroe Doctrine in the early 1820s.  In the near term, this worry is overdone.  Longer-term, if the U.S. continues to damage its sovereign creditworthiness, i.e. by not putting in place a medium-term fiscal consolidation program (that is, to reduce America’s rising government debt) – a program that should include putting health care reform on hold, then America’s relative decline will accelerate and this will affect its projection of power in the Western Hemisphere. 

In the 1820s, as revolution in Spain led to unrest in its colonies in the Western Hemisphere, the Holy Alliance of autocratic east European courts – Russia, Austria and Prussia, threatened to intervene in these colonies.  President Monroe in 1823, backed by the British Navy, warned Europe that any extension of European power to the Western Hemisphere would be “dangerous to our [U.S.] peace and safety.”

Nowadays, as the world moves increasingly toward a multipolar system, power projection in Latin America is largely in the form of commerce.  China, India and others seek, above all, the region’s raw materials to fuel their rising economies.  True, with economic influence comes political influence.  True as well, such powers as Russia and Iran seek direct political influence through arms sales and energy deals with the likes of Chavez’s Venezuela, Cuba, and Evo Morales’s Bolivia.  But these countries are on the fringe.  More of interest to U.S. policymakers are China’s economic relations with the major economies of the region, notably Brazil.  China’s economic relations with Brazil have been hand in glove — raw materials fueling a manufacturing juggernaut, while with Mexico, they have been competitive.  Brazil is also a manufacturing nation and will one day find China an unwelcome competitor. 

So, the thrust of the foreign “intervention” is commercial and good for Latin America.  This is good for the United States as well, insofar as China supports growth in the region and the U.S. no longer has to be relied on so heavily as the source of demand and investment for the hemisphere.  In previous U.S. downturns, Latin countries hovered on the brink of default (or in fact defaulted), whereas this crisis they have weathered, due in part to demand from China and elsewhere. 

China, for its part, is “intervening” in Latin America as a rule-abiding member of the global capitalist system, wrought by the U.S. and its allies.  This should not worry American policymakers.  Sure, they should keep an eye on the mischief-making of countries like Iran and Russia that seek to upset the U.S. in its own backyard, much as Krushchev did with Cuba in the middle of the last century (however less dramatic and threatening the current mischief-making is).  Again, the smartest thing U.S. policymakers can do is get America’s fiscal house in order – by first of all, postponing health care reform — and revive the formidable U.S. economy — upon which the country’s power projection is based — not least through continued banking overhaul, workout of real estate loans, policies to increase household savings, and a reform of monetary policy (by discarding Greenspan’s discredited approach).

The NYTimes published an article today detailing a set of energy deals concluded between Russia and Turkey in Ankara, with Prime Ministers Putin and Erdogan present.  The deal was with Russian energy giant Gazprom, allowing state-owned Gazprom access to Turkish territorial waters, a benefit Russian czars and party chairmen since Peter the Great (pictured above — who ruled Russia from 1682-1725) have sought by force (or threat of force).  Now, in true “Western” fashion, Russia, Inc. is signing a business contract that provides benefits to Turkey as well.  Turkey desires to become an energy hub and has obtained a Russian commitment to build a pipeline across its territory.

The Times article explains how Western interests have competed with Russia for energy agreements with Turkey in order to avoid Russian dominance of the Eurasian energy pipeline system, and the consequent vulnerability of energy-hungry Western Europe.  Russia has used pipeline cutoffs before for political purposes, e.g. with the Ukraine.

Turkey for its part, with a less pro-Western government than heretofore, headed by the moderate Islamist AKP party, probably does not mind playing what the Brits over a century ago called, “the Great Game,” or the Great Power competition in the East.  Has Vlad the Great bested Peter??

…Africa’s second largest economy and a potential rising regional power.

Nigeria, with about $215 billion in GDP last year, follows South Africa and leads Egypt in Africa in terms of the size of its economy, but lags both countries in wealth per head, with roughly $1350 of GDP per capita.  Nigeria relies very heavily on oil exports to fuel its economy.  Recent high oil prices have provided this classic developing country — with its poverty, mineral wealth, political instability and corruption, as well as reforms and emerging institutions —  with strong GDP growth and a strong external balance sheet (foreign exchange reserves in excess of government liabilities to foreigners).  With 155 million people, 250 ethnic groups, many languages, and a 50%-40% Muslim-Christian divide (view map below), this simmering rising power in West Africa is one to watch, if not next year, then some time this century.  Check out the CIA Factbook on Nigeria.

Of note is the ongoing conflict between the government and Islamic militants, putting Nigeria right smack on one of Huntington’s fault lines between civilizations.  See this article on recent unrest. 

Of interest as well is Fitch’s report on Nigeria, published last month, when the agency affirmed the country’s sovereign ratings.  See below.

“Fitch Affirms Nigeria at ‘BB-’/'BB’: Outlook Stable   

03 Jul 2009 6:30 AM (EDT)

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Fitch Ratings-London-03 July 2009: Fitch Ratings has today affirmed the Federal Republic of Nigeria’s Long term foreign and local currency Issuer Default Ratings (IDR) at ‘BB-’ and BB’ respectively. The Outlook is Stable. At the same time, Fitch has affirmed the Short-term foreign currency IDR at ‘B’ and the Country Ceiling at ‘BB-’.

“Nigeria’s strong sovereign balance sheet is the main support to its ratings. Although weakened by a major reserve loss since September 2008, its balance sheet still stands out amongst its rating peers,” says Veronica Kalema, a Director in Fitch’s Sovereign Department.

“Earlier banking sector consolidation also resulted in a well-capitalised banking system, which together with Nigeria’s strong overall and public net external creditor position and low government debt, have helped cushion the economy against the collapse in oil prices, the global recession, a reversal of capital flows and the banking sector’s exposure to a sharp fall in equity prices. With some signs of global stabilisation now apparent and a recovery in oil prices, Nigeria looks likely to weather the shocks,” adds Kalema.

The government moved swiftly to base the 2009 budget on a lower benchmark oil price of USD45/barrel (Fitch has a forecast of USD55/barrel for 2009 and the oil price is currently around USD70/barrel). Nevertheless, oil production shortfalls below the budgeted 2.3 million b/d continue to present a serious revenue challenge. However, this will be offset by the higher- than- budgeted oil price, reduced disbursements from the Excess Crude Account (ECA) and likely under-execution of the Federal Government (FG) budget. The domestic debt market provides financing flexibility for the FG and a few sub-nationals that have started to tap it to fund development spending. Nevertheless, sub-nationals face a serious revenue squeeze, and there is a risk that this will result in further disbursements from the ECA. Fitch forecasts small budget deficits at the FG and consolidated government levels and continuing low public debt of 12% of GDP in 2009, well below the ‘BB’ median.

The Central Bank of Nigeria (CBN) at first used reserves to support the naira in the face of lower oil revenues and capital outflows in the second half of 2008. Amid some confusion as to its policy goals, which heightened speculative pressure, CBN starting in late November eventually engineered a roughly 20% depreciation and stabilised the market, albeit by resorting to a temporary reversal of foreign exchange liberalisation. The naira is now at a more realistic rate consistent with lower oil prices and restrictions have begun to be eased. Despite a significant depletion of reserves by 28% to USD44.8bn in May 2009 since the peak of USD62.1bn in September 2008, low foreign liabilities of both the public and private sectors mean that Nigeria’s external balance sheet remains robust and is still one of the strongest in the ‘BB’ category. The recent increase in oil prices, if sustained, should slow the pace of reserves depletion. However, the reserves cushion has been eroded and any renewed bout of lower oil prices would likely trigger further downward pressure on the exchange rate, accelerate reserves depletion and is likely to bring negative rating action.

Unlike other countries in the region, Nigeria’s banking system has been under strain due to margin loan exposures to the sharp fall in equity prices. The loss of confidence together with lower oil revenues has also resulted in a liquidity squeeze on the money markets which, despite measures to inject liquidity, is still not fully alleviated. Although the system’s high capitalisation means that it can absorb the bulk of the losses without any support from the sovereign, the problems have exposed severe weaknesses in banking regulation and risk management. These will be the key focus of the new central bank governor, Lamido Sanusi, who as a former banker is well-qualified to address them so as to restore confidence in the financial system so that it can better support real sector development.

Nigeria’s ratings are hampered by data weaknesses and lack of transparency in several key areas including public finances, the balance of payments, international reserves and the banking system. Improvements are essential to enhancing creditworthiness.

Following an average of 6%+ growth in 2004-2008, in 2009 growth will slow to around 3%, reflecting much lower fiscal spending, private credit growth, remittances and oil prices/production. However, this will be in line with regional growth and much higher than the ‘BB’ median. Reforms and investment in infrastructure have slowed under the current administration, although there are now signs of revival. Niger Delta (ND) insecurity has further reduced oil production this year and is an ongoing rating constraint. More broadly, it has adverse implications for the government’s power and gas sector strategies necessary for further diversification and raising Nigeria’s growth potential. Improvements in the ratings will also depend on sustaining non-oil growth and raising per-capita income by addressing infrastructure through investment and reforms.

A copy of the sovereign report on Nigeria will be available shortly on Fitch’s website www.fitchratings.com.

Contact: Veronica Kalema, London, Tel:+44 (0) 20 7417 6336; Richard Fox, +44 (0) 20 7417 4357

An article on a corruption investigation in Namibia related to Chinese investment there appeared in the NYTimes on Friday.  China is confronting the growing pains of being an “imperial” power, as this giant nation increases its FDI and access to raw materials and markets in Africa, Latin America and elsewhere.  Just like imperialists that came before, since the scramble for Africa in the late 19th century, bribes and other forms of less-overt control are hard to resist.  I explored China’s challenge of cleaning up corrupt practices related to international commerce in an earlier post, and my colleague David Kampf  looked into the BRICs rising profile in Africa. 

One question is whether China, as it rises, will follow the path of the U.S. (and other Western powers) of attempting to reduce corrupt practices in international commerce.  The U.S. Foreign Corrupt Practices Act of 1977 sought to eliminate the bribing of foreign officials and increase the transparency of business relations.

Africa’s largest economy, with US$276 billion in GDP, is the continent’s rising power.  With 48 million people, it is not the continent’s most populous, with a lower population than oil-rich Nigeria (155 million) and Egypt (80 million), the world’s most populous Arab nation.  But South Africa is richer than these countries, in spite of its more skewed income distribution — South Africa has a Gini index of income inequality of 57.8, similar to Brazil’s, and worse than Egypt’s 34 and Nigeria’s 43.7.   And, with unemployment of 23%, this regional power has substantial structural challenges.

A national election in April-May 2009 occurred smoothly, after an intra-ANC power struggle resulted in the resignation of President Mbeki, post-Apartheid South Africa’s second president, following Nelson Mandela, the country’s George Washington and a major moral force in the world.  The ANC holds nearly two-thirds of the seats in the National Assembly, lording over a few much smaller opposition parties.  The ANC, which has held power for fifteen years, has much more to do to overcome the country’s nagging social problems and unleash its growth potential.

Fitch Ratings affirmed South Africa’s sovereign ratings this week, with the foreign currency rating of BBB+, the same as Libya’s ratings, but higher than all the other sixteen African nations Fitch rates.  South Africa is rated the same as Mexico, a notch higher than Russia, and two notches higher than Brazil and India.  Its credit strengths include low, though rising, public debt and good, though not stellar macroeconomic performance.  The economy grows less rapidly than other BBB sovereigns, expanding an average of 4.7% per year in the five years through 2007.  Its public debt is on the rise, given much needed infrastructure spending and a severe skills shortage.  Its banking system is strong relative to other emerging market economies (EMEs).  The economy has experienced only a modest slowdown as a result of the global economic crisis.  South Africa’s ratings were given a Negative Outlook in November 2008, along with many other EMEs, as Fitch concluded that the so-called “decoupling” of these economies from what was going on in the developed world was not a reality.  Since then, South Africa seems to have weathered the storm fairly well, with capital inflows resuming, though Fitch is taking a wait-and-see attitude.   South Africa’s wide current account deficit, at over 7% in recent years, financed in part by volatile portfolio capital, leaves the country vulnerable to external shocks.

Fitch published a report on South Africa this week, and its accompanying press release can be found below. 

“Fitch Affirms South Africa at ‘BBB+’; Outlook Remains Negative   

27 Jul 2009 6:23 AM (EDT)

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Fitch Ratings-London-27 July 2009: Fitch Ratings has today affirmed all of South Africa’s sovereign ratings. The country’s Long-term foreign currency Issuer Default Rating (IDR) is ‘BBB+’ and the Long-term local currency IDR is ‘A’, while the Short-term foreign currency IDR is ‘F2′. The Outlooks on the Long-term foreign and local currency IDRs remain Negative. Fitch has affirmed the Country Ceiling at ‘A’.

“South Africa is weathering the global recession and credit crunch quite well compared to its rating peers,” says Veronica Kalema, Director, Fitch’s Sovereign group. “Although GDP will fall by 1%-2% this year, this will be far less than most ‘BBB’ category sovereigns. Political risk has also eased since April’s smooth transfer of power to President Zuma. However, the post-election political landscape and its implications for policy is still unfolding, at a time when the budget deficit is rising sharply and the current account deficit, while diminished, remains large and presents continuing financing challenges.”

South Africa’s ratings have been on Negative Outlook since November 2008 when Fitch took negative rating action on a number of major emerging markets in the face of the sudden and fast deterioration of the global economic environment in the second half of last year. South Africa has been affected mainly through trade and capital flows channels; there were large portfolio outflows in Q408 and a sharp weakening of the currency. Though portfolio flows have since returned and the rand has recovered most of the ground lost since March 2009, the combined impact of global recession and a domestic cyclical downturn will be more broadly felt in 2009. Fitch’s earlier forecast of recession has been confirmed, but the agency now forecasts that GDP will contract by 1%-2% in 2009.

Revenue shortfalls mean the budget deficit could approach 6% of GDP in the current fiscal year (FY09: April 2009-March 2010) and remain high, albeit declining, in the subsequent two years. Fitch therefore expects the government debt ratio to rise from a low of 27% in FY08 to around one-third by FY10. External debt ratios are also forecast to rise as borrowing is stepped up to finance public sector investment and the current account deficit (CAD).

Several years of prudent fiscal policy give South Africa fiscal space to weather a temporary increase in the budget deficit without the debt ratio exceeding ‘BBB’ category medians. However, the increase in debt of the broader public sector, which includes non-financial public enterprises, will be much starker, as infrastructure spending is stepped up. In the longer-term, this investment will help the country ease some of the structural constraints to a higher growth potential, which will be key to improvement in the sovereign rating.

Falling inflation and slower private credit growth in response to earlier monetary tightening is also allowing a monetary stimulus. Interest rates have been reduced by 450 basis points since December. This will help support growth in H209 and into 2010. In addition, due to tighter regulation and supervision, the South African banking sector has been relatively insulated from the global credit crunch and although banking sector asset quality and profitability are worsening in the economic downturn, the sector is better placed than most “BBB” country banking sectors to support the recovery.

Some of the imbalances in the economy are starting to ease, with credit growth slowing sharply and domestic inflationary pressures abating. The CAD is also forecast by Fitch to narrow, though to a still relatively high 5%-6% of GDP. As this will not be fully covered by increased public sector borrowing and foreign direct investment, financing will still rely on portfolio flows, presenting a persistent risk to macroeconomic stability given continued volatile global risk appetite. High wage pressures also present a challenge to public finances, inflation and competitiveness.

A smooth political transition after the fourth post-apartheid general election, the most vigorously contested so far, has reduced short-term political uncertainty, strengthened democracy and should ease investor concerns as the country navigates the downturn. However, political risk has not diminished completely. Expectations have been raised and sporadic riots are a reminder that service delivery, which is a priority for the new government, has the potential to threaten political stability unless effectively addressed.

South Africa’s ratings could come under further downward pressure if economic recovery is weaker and more protracted than Fitch currently expects, leading to a worsening of key credit indicators. A weakening of the policy environment would also be ratings negative. However, if the country navigates the downturn over the next 12 to 18 months without a sharp deterioration of its credit metrics and with macroeconomic stability intact, the Outlook would be revised to Stable.

Contact: Veronica Kalema, London, Tel: +44 (0) 20 7417 6336; Richard Fox, +44 (0) 20 7417 4357.

Media Relations: Peter Fitzpatrick, London, Tel: + 44 (0)20 7417 4364, Email:  peter.fitzpatrick at fitchratings.com.

Fitch’s rating definitions and the terms of use of such ratings are available on the agency’s public site, www.fitchratings.com. Published ratings, criteria and methodologies are available from this site, at all times. Fitch’s code of conduct, confidentiality, conflicts of interest, affiliate firewall, compliance and other relevant policies and procedures are also available from the ‘Code of Conduct’ section of this site.”