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China’s military spending spree

5 Mar

In terms of Western decline and Eastern rise it is not just the economies that are moving apart. On the day when an old hero of the 1982 Falklands War, Major-General Julian Thompson, warned just how vulnerable Britain’s South Atlantic territories are to foreign conquest because of military cuts, it was announced that Chinese annual military spending had reached $100 billion for the first time.

While the UK and its Western allies, including the United States, are planning and executing further savings on defence budgets, China and many other Asian nations are actively rearming with the latest hardware. Although an arms race has yet to begin, India and Japan are concerned at the rate of increase in China’s military spending – up 11.2% this year alone. This does not include any off-balance-sheet spending too, which is believed to add as much as 50% more than the official figure.

Rapidly expanding

China obviously rejects any notion that this extra resource allocation is anything to be feared. The Beijing government’s declaration of China’s peaceful rise is still the national mantra, and there is no acknowledgement that massive more arms spending could be seen to contradict this strategic objective. “China is committed to peaceful development and follows a national defence policy that is defensive in nature. China’s military will not in the least pose a threat to other countries” a National People’s Congress spokesman said.

Despite the smooth words, the budget increase is causing concern amongst China’s 12 Asia-Pacific neighbours – particularly when it becomes apparent that by 2015 Beijing’s military spending will have surpassed their combined defence allocation. The source of this unease is China’s increasing assertiveness over long-standing territorial claims.

The South China Sea is the likeliest flash point, given that China’s demand for full sovereignty are being resisted by half a dozen nations. Japan and India both have disputes with China too, with India having fought a 1962 war over the contested areas. Indeed, India’s Prime Minister has been quoted as saying that his country “must prepare to counter China’s territorial ambitions”.

China also has economic interests to think of. The deployment of Chinese armed police to the Mekong river area in South East Asia last year was partly to protect their investments in the region, as well as expressing their local muscle. The development of a blue water navy – as evidenced by its new aircraft carrier development – is also designed to ensure China can further protect its international interests, especially around trade.

The truth however is that no one really knows how and why China is enhancing its military capabilities. The opaqueness of the Government means that its actual and potential rivals often have to guess at what they are doing.

Luckily for America, it still has some breathing space when it comes to military superiority given that its defence spending is still five times that of the Middle Kingdom. China recognises that this means there is a significant imbalance between the two, and as such is looking obliquely at the situation to nullify the US lead more quickly than if it went into standard competition with the world’s superpower. An article written in the Harvard Asia Pacific Review sums it up so:

“Despite America’s overwhelming military superiority, China aims to exploit vulnerabilities in key US capabilities using counter-space, counter-carrier, counter-air, and information warfare to prevent the United States from dominating a military confrontation or achieving quick and easy victory.”

The US has made Asia the centre of its foreign policy for the coming century. As such, it is highly likely that it will take into keen consideration China’s rising military capabilities to stay ahead of the race. The difficulty though will be in the understanding China’s plans. So long as it keeps the world guessing at where this extra spending is going and for what reason, Beijing will be well placed to ensure that its aims and objectives are easier to achieve without resorting to actual force.

50 Cent Parties

18 Feb

If there is one thing sure to make the blood boil it is the readers’ comments below online news articles. How many times have you read a story in the Economist, or New York Times, or the Guardian, and silently raged against the trolls and misanthropes that dollop their  unwelcome thoughts on the page?

If you are in China, then hope is at hand. There is a phenomenon on the loose, open to any journalist or editor with deep pockets and shallow concerns. It is called the 50 Cent Party, and it has taken the Chinese media by storm.

Wǔ máo dǎng  (五毛党) – as the 50CP is known here – is the term for freelance internet commentators in China that post pro-Government and pro-Communist Party comments. The 50 cent part of their name comes from them being paid to make these comments every time they manage to advance the official state line or indeed just steer a thread away from disruptive topics.

As some of these partiers can earn hundreds of yuan a month – a nice top-up to standard wages in China – it is probable that the activists are motivated by a mix of nationalist and financial fever.

The Government doesn’t take them lightly: there is even an official exam that they take to become a registered partier. Indeed, they appear to have an important role in Government policy, as this leaked propaganda directive to 50 cent partiers shows. Their objective was stated as:

In order to circumscribe the influence of Taiwanese democracy, in order to progress further in the work of guiding public opinion, and in accordance with the requirements established by higher authorities to “be strategic, be skilled,” we hope that internet commentators conscientiously study the mindset of netizens, grasp international developments, and better perform the work of being an internet commentator. For this purpose, this notice is promulgated as set forth below:

(1) To the extent possible make America the target of criticism. Play down the existence of Taiwan.
(2) Do not directly confront [the idea of] democracy; rather, frame the argument in terms of “what kind of system can truly implement democracy.”
(3) To the extent possible, choose various examples in Western countries of violence and unreasonable circumstances to explain how democracy is not well-suited to capitalism.
(4) Use America’s and other countries’ interference in international affairs to explain how Western democracy is actually an invasion of other countries and [how the West] is forcibly pushing [on other countries] Western values.
(5) Use the bloody and tear-stained history of a [once] weak people [i.e., China] to stir up pro-Party and patriotic emotions.
(6) Increase the exposure that positive developments inside China receive; further accommodate the work of maintaining [social] stability

Western commentators that sigh upon reading this will be refreshed to know the depth of ill feeling against these activists. For many Chinese they represent the continued efforts of the Government to interfere in their social media lives, as my Chinese friends can all too well attest.

Yet the campaign is not all that different from some of the political techniques utilised outside China. The 2008 campaign of US Presidential hopeful John McCain attracted criticism when it emerged that volunteers were being offered prizes in exchange for seeding comments and messages supplied to them. The rewards on offer – books signed by McCain, a ride with the candidate on his campaign bus – tap into the mix of profit and politics that are the probable motivations for China’s 50 cent-ers.

Despite this, it is clear that China is in a different league – with an estimated 300,000 volunteers involved. With the internet increasing in popularity across the developing day by day, spurred on by the massive increase in access that smart phones and cheap laptops bring, it cannot be long until other authoritarian regimes start employing the same tactics – Iran may already be doing so. Not all Chinese exports are benign.

Hong Kong blogger Oiwan Lam, who has written widely on the subject, explains all in this video:

Why the West finds it hard to invest in emerging markets

23 Jan

At a time when the West’s economy is being overtaken at every corner by the emerging economies of the world, it would seem sensible for British and Western companies to be tapping into the vast opportunities of Asia, Latin America and Africa. Political leaders seemingly agree with this sentiment, as the hefty flight schedules of David Cameron, Nicolas Sarkozy and Barack Obama would attest.

Yet the vast majority of British – and indeed Western – investment still heads to Europe and North America. In 2010 these two continents accounted for half of global foreign direct investment (FDI), but the figures for Western investment in the other continents are well below this. This is despite academic evidence suggesting that emerging market returns are generally more predictable than developed market returns.

Why don’t companies invest abroad?

Many investors do not expand abroad at all, no matter whether the market is emerging or developed.  This ‘home bias’ in investment decisions is a well-known phenomenon, and its prevalence is perhaps exemplified by a 1997 report that revealed that U.S. corporations had roughly 90% of their investments in US companies.  Although globalization has lessened this figure, it is still the case that emerging markets are underweight in terms of investment – as the FDI numbers above prove.

No one knows for sure the reasons behind home bias. Casual evidence from British companies indicates that they find it difficult to invest in emerging market economies (EMEs) because their managers are often unsure of the risks. Even the Arabian Gulf Region, one of the most rewarding regions for British firms, with a large UK expatriate community and a long history of investment, suffers from the ‘fear of the unknown’.

These risks, which can be both economic and political, may be hard to quantify in EMEs. In most Western nations, a vast library of economic statistics and political analysis is publicly available for review. These countries tend to have well-developed and predictable economies and relatively stable governments. Developing countries offer less transparency and access to accurate economic or industry statistics may not exist at all.

This opacity can significantly increase financial risks of EME investment. One such example is being confident in local corporate governance. Emerging market firms are typically controlled by a large resident shareholder, normally the state or a family, who have power significantly in excess of their voting rights. Although this can be good for the company’s long-term interests, it can also cause economic issues. Some studies seem to suggest that the Asian crisis of 1997-99 was in part caused by poor governance: the close relationship between government, business and finance, typical in these economies, led to high debt-equity ratios in the corporate sector which made it more vulnerable to economic shocks.

Corporate governance aside, there are many other financial risks that act as barriers to emerging market investment. Poor credit ratings, high and variable inflation, and exchange rate controls are but three examples. Yet political risks can be just as important, and at the same time, just as hard to fathom – as Standard Chartered Bank found out in Nigeria when its entire operation there was confiscated by the Government.

Studies have shown that there are good reasons why political risk is worth considering when looking at where to invest. First, political freedom promotes private investment. Second, political instability has a negative effect on private investment. Third, policy uncertainty has a negative effect on investment decisions.

Examples of political risk affecting investment abound. One of the reasons that Zimbabwe suffers from poor FDI is that no one is quite sure about President Mugabe’s nationalisation agenda. Iraq and Afghanistan do not find it easy to attract investors because of the political instability there makes high levels of security necessary, which bumps up costs and significantly impacts on operations.

It is therefore quite easy to see why Western companies can be reticent to invest in emerging economies. Yet investment does sometimes happen. In these cases how do executives evaluate which market to enter?

Making the choice

As might be expected, the two main categories of investment risk that are generally considered are political and economic risk. They are unavoidable factors in international commerce due to the continued differences between the laws, customs and policies of foreign governments. As foreigners entering new markets, companies and individuals often lack the local market knowledge and culture to understand these differences and must depend on outside sources for information and forecasts.

Many companies start with the financial side, using indicators like market GDP, growth rates, and exchange rates. Some also use composite risk indices which look at differing aspects of political and economic risk, like the World Bank’s Country Policy and Institutional Assessment, despite evidence that seems to play down their usefulness.

Other companies will focus on specific issues that come more or less from the personal experience of the Board, perhaps where they have been let down before. Factors examined here will include the absence of contract-enforcing mechanisms and the ease of finding local agents.

There is though one more risk category that needs to be examined, and one that is often overlooked: social risk. This is where cultural factors have an impact on an investment, often at the operational level, which is not easy to spot through traditional financial due diligence.

For example, the joint venture between TNK and BP has been enormously profitable for BP, as the financial analysis predicted. But the relationship has been far from harmonious, and it may in the long-term be a strategic calamity for the British company if it prevents them taking advantage of other opportunities such as the recently blocked deal with Rosneft shows. At the heart of this has been the operational clash between the two companies. Russian managers have found it hard to work under the Western style of management, and in return British executives have not always been attuned to Russian sensibilities. The friction this has caused has exacerbated other issues like the clash on strategic direction that is the core source of disagreement today.

Risk and high return

One final problem for companies wanting to invest in EMEs is a psychological one. British and Western culture has become risk averse over the past decades, with every effort made to eliminate hazards from daily life. Many managers find it difficult to imagine investing outside of their comfort zones: for these, EME risk can never be outweighed by the increased returns expected.

This aversion does not apply to everyone, and with good reason. For emerging markets are the future, and indeed the present – African, South American and Asian GDP growth far outstrips that of the West. The fact that this is likely to be the case for years to come means that it would not be in the interests of shareholders to at least look at the possibility of investing in these emerging markets. True, they will have different risks to investing in the US or France. But the returns will be good if the companies prepare themselves properly. The West should no longer be the be all and end all for Western investment.

Why Alex Salmond could never be Chinese

12 Jan

Chinese readers of this week’s proposed referendum on Scottish secession are highly mystified by the whole issue. Here, they muse, is one of the world’s most powerful nations allowing itself to be torn apart by a small group of nationalists, and for no obvious benefit. Why, as one Hong Konger put it, would Scotland want to become even smaller?

Independence movements though are not unknown in China. Tibet and Xinjiang are both autonomous regions struggling with ethnic unrest that causes a great deal of damage to the country’s international reputation: Free Tibet t-shirt slogans are hardly conducive to friendly thoughts of the Middle Kingdom. The nation’s image in the eyes of the Western media sometimes seems forever entwined with the Dalai Lama.

Yet despite the headlines, breaking away from China is unthinkable to the vast majority of the population.  Protecting the country’s integrity cannot and will not be compromised.

There are several reasons for this. Of these, security of the people and the economy, and the concept of a single, united people, are the most important.


Security is critical to the Chinese Communist Party, which came to power partly to fill the vacuum left by decades of brutal warlord rule in a divided, post-Imperial country. Much like the Soviets did with Eastern Europe, China has created a buffer zone between the outside world and its central and eastern heartlands, a modern version of the Great Wall. It has learnt to its cost the damage that foreign incursions can make – the 1860 destruction of the Emperor’s Summer Palace being but one example – and has no intention of allowing Xinjiang and Tibet to gain independence, let alone Manchuria or Inner Mongolia.

Linked to security is the performance of the economy. Again like Russia, China recognizes the huge resource potential of its outer lying provinces. Development of these resources is central to the economic rise of the nation as a whole, which in turn is strongly linked to maintaining public order, and in allowing the country to grow in peace.

This physical and economic security is intimately linked to social harmony. Although China has had millennia of internal conflict, the fact is that it has (intermittently) lasted as one country.  This enduring integrity rests on the deeply held belief in a strong, indivisible people and culture, namely the Han, who make up 92% of the population.

What is noticeable to an outsider in China is the sheer variation of faces and features that are seen on the street: skins of every hue, eye shapes from thin to round, noses of different dimensions. Yet if you ask a local about this diversity, she will look at you blankly: “But we are all the same, we are all Han”.

The American political scientist Rupert Emerson wrote that a nation is the “… largest community that, when the chips are down, effectively commands men’s loyalty, overriding the claims both of the lesser communities within it and those that cut across it or potentially enfold it within a still greater society….” The attachment to the idea of being Han is a good example of this in action.

It is also why China has been so successful in expanding over the millennia: once Han colonists settled a region, they were expected to continue to show allegiance to the mother country. In turn their neighbours became Han too, absorbed into the general Han mass. Their previous independence is now revealed by their name and their dialects, but emotionally these distinctions are often subservient to their overall inclusion in the greater Han.

The Chinese have therefore recognized that territorial integrity goes hand in hand with the physical, economic and social wellbeing of the population as a whole. This is an important lesson for observers of the Scotland-England rift to understand. Because although the situation in China is rather different to that in the UK – there are no armed Scottish insurrection movements for a start, nor monks self-immolating (not yet at least) – there are still similarities. After all, maximising wealth, safety and happiness for as many people in the country as possible is hardly unique to Asia.

Lies and democracy

20 Dec

The China Daily today published an American writer’s list of the ‘US’ twelve biggest lies of 2012′. “I live in Washington where lying is an art form,” David J. Rothkopf wrote for Foreign Policy.

(Readers of the CD should reflect on the fact that, unlike their hawkish cousin Global Times, they very rarely criticise the US directly, but instead report critical assertions about America written by their own people. A subtle difference.)

Newt: Cold War hero

Some of the political lies of recent times are completely ludicrous, like Newt Gingrich ending the Cold War.

These ‘mis-speaking’ statements, as Hilary Clinton may have put it, are part and parcel of running a Government. Agendas need to have supporting struts, and when no actual ones are found then politicians the world over are happy to do a little invention. This applies to democracies and authoritarians alike.

Yet when American, British and European leaders don’t tell the truth they undermine a fundamental pillar of democracy: namely that our political masters should be upstanding members of the community in whom we can place our trust. If truth becomes expendable then they defile their office, and scorn the voters that put them there. There are of course times when leaders need to be careful what they say for reasons of national security – which we all understand – but when a policy has to be continually defended by mendacity then surely it is time to revisit whether the policy is the right one in the first place?

Despite the Arab Spring, democracy is not in a good place at the moment. Two democratically elected  European leaders have been usurped in favour of technocrats, and the US political system is paralysed by more bitterness and in-fighting than at any time since the Civil War.

With China and other countries showing off the economic advantages of authoritarian rule, it is time for Western democracy to stand up and be counted. A long list of lies is not going to help matters.

Here are the twelve, with CD commentary:

1. “The war in Iraq is finally over after nine years.” Rothkopf notes the US has been militarily engaged in Iraq since the early 1990 and this will likely be just the end of another installment in the long running series of US warmongering policies in the region.

2. “America’s mission in Iraq was a success.” He expresses astonishment at such a claim while Iraq is divided, undemocratic, corrupt, and the US invasion has cost USD1 trillion, thousands of US lives, hundreds of thousands of Iraqi lives, and its national reputation. US war in Iraq bears greater semblance to a full-scale “fiasco”, he says.

3. “We are winning in Afghanistan.” Rothkopf describes this one as a hot from the oven “howler” by the US Secretary of Defense Leon Panetta. Washington has strengthened the region’s extremists and the threat of instability in nuclear Pakistan is now actually higher than it was when US went in, he says.

4. Tie: “Pakistan is America’s ally” and “Afghanistan is America’s partner.” Neither Pakistan nor Afghanistan can by any “credible definition” be called a US ally. This is attested to by the animosity of Islamabad towards Washington and Kabul’s belittling of the US on the world stage, Rothkopf says.

5. “America is unthreatened by China’s growth.” A “prayer” by US Secretary of State Hillary Clinton, Rothkopf says. “It should be true. But it’s not,” he adds.

6. Tie: “Republicans are the problem” and “Democrats are the problem.” Rothkopf dubs this one as “the great lie of American politics.” He says the problem with US politics is not the parties, but the money. “The system is so resolutely corrupt that recent scandals have only resulted in more money flowing into the system and past reforms being undone,” he notes.

7. “Cutting the taxes of millionaires helps create US jobs.” There is not even one single solitary shred of evidence to support this “idiotic” suggestion, Rothkopf notes. [Personally I am not sure about this - there does seem to be some argument that lower taxes increases investment which creates jobs, but it is all a question of degrees I suppose.]

8. “This next summit of European leaders will be decisive …” Rothkopf says despite the fact that this claim has been made every few weeks for the past months, the “supposedly sophisticated financial markets” of the United States continue to fall for it.

9. “The Obama administration is committed to serious financial services reform.” The US financial system is still plagued by all the threats that instigated the 2008 recession. “Not an inch of progress,” Rothkopf says.

10. “Only nine percent of Americans approve of Congress.” “This can’t possibly be true. There can’t possibly be that many,” Rothkopf says in a stinging sarcastic tone.

11. “The operation in Libya will be over in a matter of days or weeks.” Rothkopf says the operation was wrong to begin with, “and then wrong and then wrong again for months.”

12. “I love Israel.”  Even though everyone in US politics makes such an assertion, nobody really means it, Rothkopf notes. What the politicians really mean, however, is that “I want American Jews to think I love Israel enough to vote for me and give me money,” he says



For those of you that looked at the source material, you will notice that there are actually 14 lies that Rothkopf lists. So the question is, did the CD alter the story – so in effect lie – or did they just make a mistake?

Out of interest, the lies that the CD missed were:

  1. “The US might default on its debt”. This would obviously have a huge impact on China, which is the biggest single holder of US debt.
  2. “We believe diplomatic pressure may stop Iran’s nuclear program”. Again, a touchy subject for China given its support for Tehran.

It seems we can never be sure of the truth.

Kim Jong-il dead: what next?

19 Dec

One thing springs to mind on hearing about the death of Kim Jong-Il: uh-oh.

The despot ridiculed by many as a heavy drinking, perverted odd-ball has finally died after years of ill-health. The world is becoming rather concerned about what happens next. Share in Seoul are already tumbling, and Japan and South Korea are preparing for the worst. America and Europe are keeping highly abreast of the situation.

A figure of fun with blood on his hands

The reason is that North Korea – the last Stalinist nation on earth – is highly unstable, with enormous internal problems. Famine has been widespread over the last few decades, leaving perhaps a million people dead. Millions of others have been left destitute by misjudged economic reforms that have established, abolished and then re-established limited private markets.

Tens if not hundreds of thousands have either escaped or been caught in the attempt. At least a similar number are assessed to be waiting for their time to flee the country.

Its internal issues are made worse by the fact that North Korea is now nuclear armed and with an army twice the size of China’s. The military has a long record of unprovoked assaults on its neighbours, from mass kidnappings of Japanese citizens to the shelling of a South Korean island and the murder of American servicemen.

The chance of something untoward coming out of the death of Kim Jong-il is thus rather high. The impact of wider instability would be quite immense.

Unfortunately, the opaque nature of North Korea means that no one really knows what is going to happen now. There are though some key issues which need to be considered to have even an inkling.

First is whether the heir apparent, Kim Jong-un, can secure the succession. The second is whether the new ruler will feel the need to mount a show of force to prove himself. Third is what China does.

A stable power handover?

One of the key problems that will be faced in the coming days, weeks, months and even years is how securely Kim Jong-il’s son, Kim Jong-un, can takeover the leadership of his father. Despite being named as the Great Successor, he is not guaranteed to inherit Kim Jong-il’s communist throne.

One of the weaknesses to his claim is the lack of time he has been groomed to take over the leadership.

Kim Jong-un. A wrong 'un?

As a comparison, when Syria’s Bashar al Assad took over from his own father, Hafez al-Assad, in 2000 he had had 6 years to be groomed for the role – not a long time in the scheme of things, but unavoidable given the untimely death of the heir apparent, Basil al-Assad. Al-Assad senior smoothed the succession in three ways.

First, support was built up for Bashar in the military and security apparatus. Second, Bashar’s image was established with the public. And lastly, Bashar was familiarized with the mechanisms of running the country.

Unfortunately, none of this has been possible for Kim Jong-un.

For a start, he is only in his twenties (no one knows his exact date of birth) and has apparently spent many years abroad. This means that he has probably not had enough time to build up strong political relationships or power-bases to guarantee his succession, despite a PR campaign that included making his holiday a national holiday. It is also unclear as to how well he understands the political system and how to manipulate it to his own benefit.

As Kim Jong-un has been named as head of the funeral committee and Great Successor, it is likely that he has at least some kind of hold on power currently. But given that the North Korean political hierarchy is almost completely unknown to outsiders, it is hard to say if there is anyone who is positioning themselves to make a challenge to the heir presumptive over the coming months.

The good news is that if there is a challenge to Kim Jong-un’s reign then it is more likely that it will be dealt with internal to the hierarchy, rather than spilling out to a wider war.

Show of strength

Even if succession goes well, the next risk is if Kim Jong-un is pushed to make a strong-man stand to prove himself. This could quite easily take the form of a military strike on South Korea, which the North has a long track record in doing.

Getting ready to march?

If this were to happen then it could not come at a worse time. Given the impotence of the SOuth Korean military’s response to a shelling incident earlier this year, and the sinking of a warship that left 46 dead, there is considerable pressure on the South to massively respond to any North Korean aggression.

This would obviously have serious consequences in the region, and most likely lead to a sharp war unless the sides were restrained by their allies.

What China thinks

Allies though is not what North Korea has in plenty. China is their last major supporter on the world stage. Despite Kim Jong-il’s horrendous treatment of his Chinese sponsors – the pinnacle being him not telling them he was about to test a nuclear bomb in 2006 – China have stuck with him. This is mainly for geopolitical reasons, namely that the last thing Beijing wants is a reunited Korea allied to America on its borders. They will therefore do anything they can to keep the country divided.

What China don’t want either is for North Korea to implode. This would undoubtedly lead to hundreds of thousands (if not millions) of refugees trying to get across the border, causing instability to China and raising regional tensions.

The best result for China therefore is for an orderly transition to Kim Jong-un – or any leader capable of keeping the country together – and the maintainance of the status quo.

It might be assumed that China would have opposition to this. However, although there will be hawks in Seoul, Tokyo and Washington that demand regime change, it is highly likely that orderly succession will be wanted all round. The main reason is the cost of not having it.

For a start, regime change would be highly likely to lead to a conflict that would drag in the US, South Korea, and probably China and Japan too. No one wants that. Second, the cost of reunification – a likely byproduct of such change – is absolutely staggering, with estimates ranging up to $5 trillion. This is five times the total annual GDP of the South, and is simply unaffordable without outside help – but with the world economy in tatters, who would be able to give such assistance?

No one wants this

In the absence of any desire by the West to see Kim Jong-un fail, China is likely to get its way. They will also in all probability try to act as a brake to any misguided attempt to attack the South.

That said, this does depend on China still having the ear of the new North Korean leader. If China felt that it was being ignored and that the North Koreans needed reigning in for whatever reason, then regional tensions would rise – with unknown results.

In other words

Given the rapidity of the regime in anointing Kim Jong-un as Great Successor, we are probably going to see Kim Jong-un take over from his father, supported by Beijing. It is also unlikely that they will lash out at anyone, at least in the foreseeable future – especially if China has its way. However, until there is more certainty emanating from Pyongyang, the markets – and neighbouring governments – will remain rather jittery.

The caveat though has to be that no one really knows what is going on inside the Hermit Kingdom. Time is the only way we will know the future.




France’s economic outlook downgraded

17 Dec

“We would prefer to be French right now than British” said Francois Baroin, France’s Finance Minister yesterday.

M Baroin perhaps regretted those words when Fitch, the ratings agency, made the first move on the forthcoming assault on France’s AAA rating by revising their outlook to negative from stable.

Really, Minister?

This negative outlook means that although a downgrade in credit rating is not imminent, there is, according to Fitch, a “slightly greater than 50% chance of a downgrade over a two-year horizon.”

Fitch don’t stop the kicking there though: “Relative to other ‘AAA’ Euro Area Member States, France is in Fitch’s judgement the most exposed to a further intensification of the crisis.”

To reiterate, the reason this is important is that should France have its credit score downgraded then it will have to pay more to borrow. Given the parlous state of France’s banks, the Paris Government needs to have its economy as fit as possible to absorb the huge losses that could come their way should the banks need to be bailed out. Add to this the fact that 2012 is going to be an important year in terms of re-financing, both sovereign and private, and any increase in borrowing cost would be have a serious impact on the wider French economy.

The truly hurtful thing about the downgrade, from a French point of view, was that the Fitch team that made the call was based in…London.

Fitch Ratings-London/Paris-16 December 2011: Fitch Ratings has today affirmed France’s Long-term foreign and local currency Issuer Default Ratings (IDRs) as well as its senior debt at ‘AAA’. Fitch has also simultaneously affirmed France’s Country Ceiling at ‘AAA’ and the Short-term foreign currency rating at ‘F1+’. The rating Outlook on the Long-term rating is revised to Negative from Stable.

The affirmation of France’s ‘AAA’ status is underpinned by its wealthy and diversified economy, effective political, civil and social institutions and its financing flexibility reflecting its status as a large benchmark euro area sovereign issuer. In addition, the French government has adopted several measures to strengthen the creditability of its fiscal consolidation effort. Nonetheless, government debt to GDP is currently projected by Fitch under its baseline scenario to peak in 2014 at around 92%, higher than any other ‘AAA’-rated sovereign with the exception of the UK and US and significantly higher than other ‘AAA’-rated Euro Area peers.

France’s sovereign credit profile benefits from a broad and stable tax base – the volatility of the revenue to GDP ratio is half the ‘AAA’ median – and the interest service burden is moderate and broadly comparable with other ‘AAA’s. Under Fitch’s baseline scenario that does not incorporate the realisation of substantial fiscal liabilities arising from the Eurozone crisis or other adverse shocks, even such an elevated level of government indebtedness is consistent with France retaining its ‘AAA’ status assuming that government debt is firmly placed on a downward path from 2013-14. The Negative Outlook on the French rating reflects Fitch’s view that the likelihood of the realisation of contingent liabilities, although still not our base-case assumption, has materially increased, as has the risk of a much worse than expected economic and consequently fiscal outturn.

Similar to other highly rated peers, France faces medium and long-term challenges to improve the functioning of the labour market and enhance international competitiveness. Fitch recognises that the authorities have adopted measures to address these weaknesses, though a more radical structural reform agenda would underpin greater confidence in the underlying potential growth rate of the French economy. However, corporate and especially household indebtedness is moderate compared to some ‘AAA’ peers, notably the UK and US, while foreign indebtedness remains modest, albeit rising.

The Negative Outlook is prompted by the heightened risk of contingent liabilities to the French state arising from the worsening economic and financial situation across the Eurozone, as reflected in the Rating Watch Negative placed on the sovereign ratings of several Euro Area Member States (EAMS) on 16 December 2011. As Fitch commented in its report on 23 November, ‘French Public Finances’, the fiscal space to absorb further adverse shocks without undermining its ‘AAA’ status has largely been exhausted.

The intensification of the Eurozone crisis since July constitutes a significant negative shock to the region and to France’s economy and the stability of its financial sector. Since May, when Fitch last affirmed France’s ‘AAA’ status, its forecast for economic growth in 2012 has been cut from 2.1% to 0.7% with around one-in-four chance of outright contraction. Despite the additional fiscal measures announced in August and November equivalent to around 1% of GDP, further measures are likely to be required in order to cut the deficit to 3% of GDP by 2013 and stabilise government debt below 90% of GDP in light of the worsening economic and financial outlook.

In Fitch’s opinion, the commitments made by leaders at the EU Summit on 9-10 December and by the ECB were not sufficient to put in place a fully credible financial firewall to prevent a self-fulfilling liquidity and even solvency crisis for some non-AAA euro area sovereigns. In the absence of a ‘comprehensive solution’, the Eurozone crisis will persist and likely be punctuated by episodes of severe financial market volatility.

Relative to other ‘AAA’ Euro Area Member States, France is in Fitch’s judgement the most exposed to a further intensification of the crisis. It has a larger structural budget deficit and higher government debt burden relative to Euro Area ‘AAA’ peers. Moreover, relative to non-Euro Area ‘AAA’ peers, notably the US (‘AAA’/Negative Outlook) and the UK (‘AAA’/Stable Outlook), the risk from contingent liabilities from an intensification of the Eurozone crisis is greater in light of its commitments to the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM), as well as indirectly from French banks that are less strong than previously assessed as reflected in recent negative rating actions by Fitch.

The Negative Outlook indicates a slightly greater than 50% chance of a downgrade over a two-year horizon. The triggers that would likely prompt a rating downgrade are as follows:

- Increased likelihood that contingent liabilities from an intensification of the Eurozone crisis will be crystallised onto the French state balance sheet.

- Material slippage from the fiscal targets that the government has set itself, notably the aim of stabilising the government debt to GDP ratio from 2013 and placing it on a firm downward path towards levels that would increase the ‘fiscal space’ necessary to absorb adverse shocks.

- Weaker than expected economic performance that prompts a re-assessment of France’s medium to long-term growth potential.

Conversely, economic and fiscal performance in line with Fitch’s baseline expectations, as set out in the Special Report, French Public Finances (23 November 2011), along with the resolution of the Eurozone crisis would likely result in the stabilisation of the rating Outlook.

In the absence of a material adverse shock, most likely associated with dramatic worsening of the Eurozone crisis, Fitch would not expect to resolve the Negative Outlook until 2013.


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