“Abenomics”, formulated by a group of “reflationists”, is about firing “three arrows” at Japan’s economy with the aim of pulling it out of two decades of deflation-ridden, stop-start growth. These three shots include full bore monetary policy, aggressive fiscal policy and a big slug of structural reform. If successful, policymakers around the world could adopt the strategy.

Second-time Prime Minister Shinzo Abe, whose Liberal Democratic Party prevailed in lower-house elections in December, is hoping his revolutionary brand of economics will end Japan’s time as the textbook model of how asset bubbles can debilitate an economy.

Since these bubbles popped in the early 1990s, Japan’s economy has remained in the doldrums despite near zero interest rates, the invention of quantitative easing in 2001 and massive fiscal stimulus that has boosted net public debt to about 130% of output (and gross debt beyond 230% of GDP).

The reflationists (who mainly comprise academic economists) believe a major reason behind successive government failures to remedy the situation has been the half-hearted and muddled application of monetary and fiscal stimulus to date. They want to end these errors with a three-pronged strategy.

The first arrow revolves around bullying the traditionally cautious Bank of Japan into adopting an inflation target of 2% within two years. The second arrow is already-announced fiscal stimulus that amounts to about 2% of GDP in 2013. The third arrow is microeconomic reform, which includes dismantling protectionist practices and trimming red tape for businesses.

The reflationists are aiming for sustained GDP-per-capita growth of 1% to 1.5%, in line with the targets for most developed economies. While the experiment is off to a promising start with the public and investors (the Topix has surged 36% in the first four months of this year), its long term success is far from assured.

Japan equity and yen performance

Three arrows
With monetary policy, the Bank of Japan under the Abe-appointed reflationist Haruhiko Kuroda is implementing the world’s most-aggressive quantitative easing, whereby a central bank buys assets from banks to boost the monetary base, which comprises bank reserves with the central bank plus cash in circulation.

The Bank of Japan unexpectedly announced in April that it intends to double the monetary base over the next two years.

The economic theory behind the move is that a rise in asset prices tied to easier monetary policy will reduce real interest rates and thereby fan economic growth, tax receipts and inflation. An added benefit for export-tilted Japan is that looser monetary policy also has the effect of weakening the yen, which slid 11% in the first fourth months of this year – a decline that will stir inflation via higher import prices.

The Bank of Japan’s revolutionary move has its doubters. The core challenge is that because deflation is so entrenched, it’s questionable whether the quantitative-easing efforts will create the negative real interest rates that Japan needs to encourage the investment and spending that fan economic growth. The opposite danger is that Japan could stagger from deflation of minus 0.5% in the 12 months ended March (for a total price decline of about 20% since 1997) to an out-of-control price spiral.

As part of the second arrow, Abe’s government in January announced a supplementary budget containing stimulus worth 10.3 trillion yen that widens the fiscal deficit for the year close to 10% of GDP. The first risk with this strategy is that it adds to government debt. The second problem is that any short-term gain in economic activity could be nullified further down the line if the government imposes austerity in an attempt to reduce the country’s debt pile.

Abe’s third arrow is a commitment to business deregulation and vague support for a US-led trade pact for the Pacific that would include Australia. A reduction of tariffs among Pacific-rim countries could open protected areas of Japan’s economy, especially agriculture. However, many would argue that this third policy strand needs more meat on the bone to be effective.

A huge gamble
Critics of Abenomics say the strategy fails to address core problems within Japan’s economy and holds unintended risks. Japan’s aged population won’t enjoy seeing their savings lose value if inflation rises; it might even make them save harder. Nor will workers like a drop in their spending power if inflation accelerates.

Trading partners might react adversely when faced with a lower yen and implement protectionist measures. Japanese savers might look overseas to invest if bond yields drop, which will shrink a major pool of government funding and, if there is a large enough stampede, could torpedo the yen and trigger runaway inflation.

Tokyo’s debt commitments, which already gobble up at least one quarter of tax revenues, will soar if bond yields rise with inflation. Japan’s banking system would wobble if government yields jump, so stuffed are they with these securities.

This has led many observers to dub Abenomics a huge gamble. It largely assumes that deflation is a monetary phenomenon rather than a demand-driven or structural problem. Much of Japan’s lethargy is due to a lack of business investment and consumer spending – a persistent lack of domestic demand.

On the investment side, Japan’s problem is that companies save too much of their excessive oligopoly-driven profits because they have been scarred by the popping of bubbles in the early 1990s and Japan’s ageing society presents few new business opportunities.

Consumer spending remains subdued in Japan because of the rise in the number of Japanese who exist on part-time or temporary contracts. Lack of job security means the Japanese are not big spenders and the poor economic environment means they are forced to work for low wages. It’s estimated that 35% of Japan’s workforce are either part time or casual workers while wages have fallen about 10% since 1997.

So Abenomics is a high risk strategy, with many potential flaws, but it’s also fair to say Japan’s policymakers are making their best effort since the bubble burst over 20 years ago to escape stagnation. They could well succeed in stirring their economy. If they do triumph, all over the world newly-converted reflationists will be clamouring to fire three arrows at their limp economies. If they fail, Japan will enter uncharted territory.

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China’s shrinking workforce has big repercussions

The coming years will be favourable ones for Chinese workers seeking hefty pay rises. A big contraction in the labour force will help their bargaining position no end, as it upturns China’s economy.

To understand the test confronting China it helps to canvass the work of an economist from the Caribbean island of Saint Lucia who won the Nobel Prize in Economic in 1979 for his theories on development.

The “dual sector model” of Sir Arthur Lewis (1915-91) purports that economies advance without triggering inflation because the expanding industrial sector can scoop up labour from the subsistence primary (agricultural) sector [1]. 

 Basically, an unlimited supply of peasants willing to work in factories for low, but not subsistence, wages allows the industrial sector to power ahead by earning, then reinvesting, excessive profits. But there comes a time when the supply of surplus labour peters out and developing countries confront a labour shortage. The point at which an abundance of labour is about to vanish is known as a “Lewis turning point”.

Among its symptoms: wage increases outstrip productivity, industrial profits decline, investment drops and inflation becomes a threat.

A Lewis turning point can loom ahead for any developing economy. China’s problem is that it is charging towards an unprecedented Lewis turning point. China’s challenge is that the exhaustion of surplus peasant labour is coinciding with what is often called the country’s “demographic time bomb,” a rapid ageing of its 1.3 billion population tied to the three-decades-old, one-child policy.

As the IMF warns, “demographics will be the dominant force driving the depletion of surplus labour” [2] and not industrialisation. Another way to think of this problem is that China is poised to become an aged society before it is rich enough to support an ageing population.

Such are the economic consequences of the decision in the late 1970s to restrict urban couples to one child that is estimated to have reduced China’s population by a third [3].

(Rural couples and ethnic minorities, among others, are allowed more children so the birth rate is higher than a strict one-child policy would allow. The global replacement fertility rate is about 2.1 children per woman. The rate is higher for developing countries because of their lower life expectancies.)

Counter steps
What was the China miracle but the marshalling of cheap labour? The IMF forecasts that China’s present labour surplus of about 150 million people will drop to 30 million by 2020 and that the Lewis turning point will occur about five years after that [4].

The IMF projects that by 2030 China could have a labour shortage of 137 million workers and it envisages scenarios where this number could exceed 200 million people.  A more immediate concern from the one-child policy is that China’s core working-age population, those aged between 20- to 39-years-old, is already shrinking.

China’s National Bureau of Statistics said the number of working-age Chinese fell by 3.5 million in 2012 [5]. This trend helps explain the 12% to 15% jump in wages across China in the past decade and the labour shortages dogging manufacturers in coastal provinces.

As the idea of scenarios suggests, China’s government can take steps to slow the arrival of the Lewis turning point, even though the IMF warns the “looming demographic changes are large, irreversible and inevitable in the medium term” [6]

Authorities can relax the one-child policy and encourage greater labour-force participation, especially by loosening restrictions on people moving around China. (The hukou or household registration system segregates urban and rural Chinese economically and socially to prevent political disruption.)

Policymakers can take steps to boost productivity and encourage the services sector to expand. They can skill their citizens and encourage investment in agriculture to free more peasants and in automatic and capital-intensive industries to dilute demand for staff.

Foxconn Technology, a Taiwan-based company that employs about 1.2 million people across China making electronic gadgets for companies such as Apple, Microsoft and Hewlett-Packard, plans to have almost as many robots as people in its factories within three years, to cope with China’s looming labour shortage.

Implications
The consequences for China and the rest of the world of a labour shortage in China play out endlessly. China’s workers will enjoy greater bargaining power and wages will assume a larger proportion of GDP. Strikes at plants run by Japanese car makers and Foxconn are signs that China’s workers can sense the upper hand in negotiations over pay and conditions.

Bad publicity around the world on conditions in Chinese factories following a string of suicides is also forcing foreign companies to improve conditions in China. Higher wages would help policymakers achieve, almost by default, their goal of turning China’s economy into one driven more by consumption than investment and exports.

Rising labour costs imply China will face higher inflation, which is now about 4%. After being a source of deflation for the rest of the world over the past three decades thanks to its cheap toys and shirts, China may export inflation.

While it won’t be like an oil shock in its immediacy, its effect will be just as far-reaching over time. China’s deflation, after all, allowed Alan Greenspan to keep US interest rates low enough to create a housing bubble and trigger a global financial crisis.

A shrinking labour force would imply slower GDP growth (though not necessarily lower GDP-per-capita growth.) Government finances will be stretched as they support more retired people. A slower Chinese economy would signal less demand for commodities, a shift that would hit Australia’s exports and hamper our economic growth. But the rest of the world will gain overall if Chinese workers have more money to spend and businesses invest in automation.

Consumer and capital imports might grow to such an extent that China will become, like Australia, a country that posts record perennial current-account deficits instead of surpluses, a transformation that would herald a major rebalancing in the world economy.

Saved by exports
The big danger is that China fails to boost productivity as the workforce shrinks and economic growth slows to below 5%. Higher wages mean lower profits and less investment. Bigger wages bills, the steeper costs associated with improving working conditions, greater industrial unrest (2,000 workers rioted and 40 were injured at a Foxconn plant making iPhone components in Taiyuan in north China in September) and a disdain for boring factory work among many of China’s young are driving production out of China to elsewhere in Asia and even back to the US.

Workforces in Asian countries such as India, Indonesia and Vietnam are about half the cost of Shanghai’s minimum wage. The Boston Consulting Group said faster inflation and higher wages in China will reduce the cost gap between the US and China from 55% in 2005 to 39% by 2015, a figure that goes even lower in overall terms after adjusting for higher US productivity and become virtually zero for many goods [7].

Companies are already responding to these cost shifts. US chip-maker Intel and Taiwan manufacturers Hon Hai and Compal have just opened factories in Vietnam while General Electric and Apple have moved some production back to the US.

Economists regard developing economies that stagnate after blazing away for a while as falling into the “the middle-income trap” (a theory, it must be said, some analysts are cynical about because economies can get stuck at any income level). A study in 2012 by two Asian Development Bank economists estimates that 35 of 52 middle-income countries in Latin America, the Middle East, Africa and Asia are stuck in this hole [8].

They say economies with diverse, sophisticated and off-beat (or non-standard) export bases best navigate their way through middle-incomeness to become high-income countries. China, the world’s biggest exporter, can boast this attribute because Chinese are innovative, making more sophisticated products, enhancing the quality of their goods and developing brands.

While its lack of rule of law and other flaws associated with its one-party political system will be a drag, China’s export prowess and expected leaps in productivity should help its shrinking workforce enjoy wage increases for years to come, especially among the lower paid even if they don’t push so hard.

Financial information comes from Bloomberg unless stated otherwise.

Important information
References to specific securities should not be taken as recommendations.
Investments in small and emerging markets can be more volatile than investments in developed markets.
Investments in overseas markets can be affected by currency exchange and this may affect the value of your investment.

1 Lewis, W. A. “Economic development with unlimited supplies of labour.” The Manchester School, 22. 1954. Pages 139 to 192.
2 IMF Working Paper. Research Department and Asia and Pacific Department. “Chronicle of a decline foretold: has China reached the Lewis turning point?”. Prepared by Mitali Sas and Papa N’Diaye. January 2013. Page 1.
3 Financial Times. “China performs 330m abortions in 40 years of enforced family planning.” Page 1, 18 March 2013. Online version can be found at http://www.ft.com/intl/cms/s/2/6724580a-8d64-11e2-82d2-00144feabdc0.html#axzz2NrrAWtA5
4 IMF. Op Cit. Page 15. Figure 6. Baseline scenario: surplus labour.
5 The Economist. “Peak toil.” 26 January 2013. http://www.economist.com/news/china/21570750-first-two-articles-about-impact-chinas-one-child-policy-we-look-shrinking  
6 IMF. Op. Cit. Page 8.

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China – rising inequality poses a political and economic menace

China’s now-disgraced ex-politburo member Bo Xilai revealed one of China’s most sensitive pieces of information just before he was ousted from his leadership role last year.

No, it wasn’t a military secret, some diplomatic manoeuvre, nor some political machination. It was just a number, but one that rattles China’s regime.

Bo told journalists a year ago where China’s Gini coefficient stands. This measure of income inequality named after its inventor, Carrado Gini of Italy, is at 0.46 for China and if only a few people are wealthy “we have failed,” Bo said [1].

China’s ratio has shot up from about 0.3 in the early 1990s to beyond the 0.4 level that is often taken as the marker where inequality leads to social unrest. With the index, zero represents perfect equality and one stands for perfect inequality – as in the richest hog all.

The rise in inequality is a common flaw of most of the developed and developing societies that have thrived under free-market economic reforms in recent decades. The beliefs of unbridled capitalism generally hold that free trade and unfettered exchange promote prosperity, that markets and private enterprise are efficient and that government interference, in the form of higher taxes, regulations, subsidies or welfare transfers, generally stifles wealth creation.
In practice, the reign of free-market beliefs has meant that governments favoured capital over labour at a time when new technology and the globalisation it enabled eroded the bargaining power of the semi-skilled and unskilled.

The highest marginal income-tax rates were slashed (from 70% in the US in 1980 to 39.6% now) while other taxes that hit the rich hardest (such as those on capital gains and inheritances) were reduced. Fighting inflation took priority over reducing unemployment. Restrictions were removed from finance and big business, as a drive to maximise shareholder value reigned, while organised labour was hobbled through regulation and outsourcing. Government assets were sold, often cheaply, and generally became the basis for privately owned monopolies.

Free-market apologists say that the extra wealth created by liberal economic policies trickles down to the masses. Everyone, more or less, is better off these days, if measured by how GDP per capita has soared worldwide over the past three decades. But many people don’t feel better off because they aren’t relatively better off.

That’s why it’s not just Chinese authorities fretting about the political and economic costs of rising inequality these days. Governments everywhere are jolted by the image conjured by the Occupy Wall Street movement – that the overlooked 99% are angry.

Investors may find to their cost that fighting inequality could become one of the defining political issues of the upcoming era. They will need to factor political risk into their decisions as authorities are under pressure to switch their focus from growing wealth to worrying more about how wealth is shared.

Long-term threat
Authorities are in a bind; fighting inequality disrupts wealth creation, but they need to battle rising inequality because it has direct economic costs and, more tellingly, produces political consequences that create economic liabilities. The Asian Development Bank rates the “startling rise” in inequality as developing Asia’s greatest long-term economic threat. The bank estimates the Gini coefficient in developing Asia has jumped from 0.38 to 0.47 over the past two decades – as in nearly 20% of total income went to the top 5% in most countries. [2]

One political consequence of inequality that turns into an economic liability is that it creates a feeling that everyone is only out for themselves. This impression undermines the social cohesion that lubricates economies and societies. As people become more fearful, selfish and insecure, corruption flourishes, crime jumps, anti-social behaviours increase, labour unrest stirs and legal disputes tied to commerce rights rise. When people feel they no longer live in a fair society or one where they have much opportunity they will eventually react. Heightened crime in Spain where youth unemployment is 50%, riots in Athens and strikes in Italy over austerity measures and mass looting by the impoverished in the UK in 2011 are signs of have-nots getting fed-up with the haves.

Rising inequality could retrigger the violent labour unrest that disrupted many countries in the 19th and early 20th centuries, until labour reforms were enacted on minimum wages and basic conditions. In South Africa, where the Gini coefficient at  0.57 shows the country has one of the world’s biggest wealth gaps, police in August killed 34 striking workers and injured 78 at a platinum mine owned by Lonmin of the UK, a week after miners killed three company officials and two police.

Inequality, when combined with economic hardship, is the essential ingredient for uprisings that topple governments. Inequality played a role in nurturing the upheavals that have swept across north Africa and the Middle East since 2010. Similar revolts are what China’s ruling Communist Party fears most.

The Chinese government concedes that tens of thousand of “mass incidents” of unrest occur each year, which can range from a few people reacting to an official decision to everyone in a village protesting as happened at Wukan in southern China in December 2011 after communal land was sold to developers. China’s rulers fret that somehow these incidents will coalesce into a nationwide revolt as the quasi-religious Taiping Rebellion did in the 1850s and 1860s at the cost of 20 million lives.

Feeding the extremes
A second economic liability created by the political fallout from inequality is that the resentment against economic injustice – epitomised by globalisation – nurtures an environment ripe for populist policies. Democracies are especially prone to this political backlash that undermines economic efficiency. The rise of Pauline Hanson’s One Nation in the 1990s and its associated economic nonsense (recall its proposal for lower interest rates for rural areas?) stemmed from lower-paid workers feeling excluded from Australia’s rising prosperity.

In Europe, extremist parties from the left and right are gaining popularity by pledging to re-nationalise industries and to shut out foreign bond speculators and cheap Chinese imports. (Far-right parties in Europe are anti-globalisation, anti-finance and anti-foreign including anti-EU, which helps them blend with the left. Far-right parties in the US are anti-government but for market fundamentalism, so implicitly support policies that promote inequality.)

In the just-held Italian election, populist candidates, Silvio Berlusconi’s coalition, and comedian Beppe Grillo’s anti-establishment movement, scored a combined 55% of the vote in the lower house, while the incumbent technocrat Mario Monti’s coalition received just 11%. (Pier Luigi Bersani’s centre-left alliance gained 30% of the vote, giving it control of the lower house via bonus seats for coming first.)

In the first round of France’s presidential election in April last year, pro-protectionist candidates from the extreme left (the Communist-backed Jean Luc Mélenchon) and the hard right (the National Front’s Marine Le Pen) attracted one in three votes, even though the mainstream candidates chased these voters with protectionist platitudes.

The rise of pro-protectionist or anti-free market, nationalistic parties across Europe is one of the biggest impediments to the banking, fiscal and political integration that would help the eurozone escape the economic mess caused by the euro’s flaws.

In the Americas, more than a touch of populism lay behind the Argentina’s decision in April last year to nationalise the 51% of the national oil and gas company YFP that belonged to Spain’s Respol, after the possibility arose that Respol might sell the company that controls Argentina’s energy assets to China’s Sinopec. In the US, where the Gini coefficient stands at 0.38, the idea that the rich are robbing the rest even twisted its way into the primary campaign of the free-market, shrink-the-government Republican Party.

Worst offenders converted
A third political threat from inequality that carries economic costs is that the concentration of economic power can undermine democracy because it gives the mega rich too much political power. As the wealthy use this muscle to expand their economic interests (via, for instance, subsidies or anti-competitive moats around their assets), the core political institutions of society are eroded. Rule of laws, fundamental rights, open debate and the electoral process are often diminished.

In Russia, the tainted sale of public assets created an oligarch class of billionaires, which now directs public policy in its interests. In the US, the wealthy’s control of the political system has only increased since a 2010 Supreme Court ruling effectively allowed unlimited spending on elections by individuals and companies.

Lastly, inequality imposes direct long-term economic costs because unequal societies prove to be faulty and inefficient economies. When too much income and wealth gushes to the top, the middle and lower classes are incapable of marshalling the purchasing power needed to fan sustainable economic growth.

The lack of aggregate demand tied to the perennial inequality of Latin America, where the Gini coefficient is 0.52, has retarded these countries economically as well as politically. Another way inequality undermines economic growth is that people don’t work as hard if they feel they are not rewarded properly. A third way is that inequality directs activity towards acquiring government-sanctioned monopolies rather than innovation.

Governments talk about tackling inequality, though many are too swamped by more acute challenges to impose decisions that may have pose a short-term threat to efficiency. US President Barack Obama has made fighting inequality a priority in his second term, though Republicans oppose his plan to boost the minimum wage by 24%. Perhaps more-stable Asia will make the most immediate progress on levelling the gap between rich and poor.

In February, Beijing released a 35-point anti-inequality plan to lift as many as 80 million people out of poverty by 2015. It included plans to lift minimum wages and force state-owned companies to return more profits to the public. Even in anything-goes Hong Kong where the Gini coefficient stands at 0.54, the new leader Leung Chun-ying has promised to pull away from the model of “small government, big market” to help the less-well-off.  On February 27 when announcing his first budget, Leung boosted spending on welfare by 31%, earmarked US$2 billion for a  fund to lower poverty and gave about 400,000 elderly an allowance.

Solutions to reduce inequality will no doubt involve higher taxes on the rich and capital gains and the closing of tax loopholes that favour the wealthy. Government will need to spend more on education, health, public works and welfare payments. Policymakers may raise minimum wages, tilt employment laws more towards labour and tighten anti-competitive regulations. It makes economic sense for governments to take up these and other ideas to combat inequality. Self interest will demand that they do anyway for that’s where the centre of politics lies, even if attempts by the rich to preserve their status polarise society at the same time.

Gini coefficients come from various OECD reports and the Asian Development Bank unless stated otherwise. For the record, Australia’s Gini coefficient is 0.30.

[1] Bloomberg News. “China’s Gini coefficient has exceeded 0.46, Bo Xilai says.” 9 March 2012
[2] Asian Development Bank chief economist Changyong Rhee quoted in “Unfair growth” release issued by the Asian Development Bank on 11 April 2012. http://www.adb.org/features/unfair-growth

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He warns that the austerity conditions tied to Portugal’s bailout are leading to a “recessionary spiral” that is “socially unsustainable”[1].

Cavaco Silva’s attack on austerity policies that have led to unemployment of 16% in Portugal is almost uncontroversial these days in terms of economic thinking. It’s clear to most that removing government stimulus from a weak economy undermines economic growth and, consequently, further fouls government finances.

Eurostat data shows how deep reductions in spending and sharp increases in taxes in Greece, Ireland, Portugal and the UK have shrunk their economies to such an extent that government finances are in worse shape. [2]

Even the IMF, a long-term fan of austerity for wobbly developing countries, has recanted. It now concedes that a dollar taken out of a troubled economy in recent years shrank that economy by more than one dollar. In economic jargon, the fiscal multiplier was greater than one, whereas proponents of austerity assumed the number would be about around 0.5. [3]

The worry for investors is that the US is imposing austerity. Politicians there are removing government stimulus from the economy in steps as they clash over Washington’s finances. Looming fights this year over the fiscal deficit, government debt, financing the government (a temporary measure allowing this expires on March 27) and the debt ceiling will no doubt heighten political anxiety and reduce business and consumer confidence in the US economy, which shrank at an annual pace of 0.1% in the fourth quarter.

There’s no question Washington’s finances need fixing. The US federal government is running a fiscal deficit equal to about 8% of GDP. Government debt has doubled to 73% of GDP in the past six years and is set to soar due largely to spending on health. Ideally, what the country needs is a plan to trim the debt-to-GDP ratio towards 60% over the next decade.

This proposal would entail phased spending cuts and higher taxes, timed so as not to sink the economy, while allowing for investment in infrastructure and education. No such plan is likely to emerge from the clashes timed around the latest artificial deadlines US politicians have imposed on themselves.

Sequester verdict

The best slant that can be cast on the deal over the so-called fiscal cliff that Congress passed on January 1 was that the expiring 112th Congress avoided the 3% to 4% hit to the US economy the associated spending cuts and tax hikes would have delivered over 2013.

But the decisions to boost income taxes on the richest 1% of taxpayers, raise the capital-gains tax, let the payroll tax reductions expire and allow cuts in discretionary and military spending will still trim government stimulus over 2013 by about 1% to 1.5% of GDP.

The US austerity hit will more or less match the self-imposed austerity blows on the UK in 2011 and 2012 that have sent its economy stumbling towards its third recession in four years. But the US austerity jolt won’t be as savage as the punches received by Greece, Ireland and Portugal. [4]

Not yet anyway. One unfortunate aspect to the fiscal-cliff negotiations was that a decision on one of the threats to short-term economic growth was postponed. The fate of the “sequester” involving US$1.2 trillion in automatic cuts over the next decade or so to military and domestic discretionary spending must be sorted out by the end of February.

The sequester came about when the Republicans insisted on spending cuts to match the increase in the federal government’s debt limit they allowed in 2011. They were designed to be draconian enough to prompt lawmakers to negotiate gentler ways to reduce government spending, as in it was never the intention they take effect.

But Republican resolve to let these spending reductions come to pass is hardening, especially since they backed down in January during the negotiations to raise the debt ceiling again. They agreed to suspend the debt limit for three months until May. Their retreat came with a requirement that Congress pass a budget by then so that both chambers of Congress can focus on lowering fiscal deficits over the long term.

Such negotiations promise to be fraught as Tea-Party Republicans appear intent on securing sweeping (but largely unspecified) spending cuts and have forced their party leadership into declaring Republicans won’t sanction any more tax increases. The Democrats appear determined to protect welfare spending, even though its ballooning cost in coming years is one of the biggest threats to sound government finances.

The most likely short-term outcome of the row over government finances is that the spending cuts tied to the sequester become law on March 1 – for it would take a new law, thus compromises by both sides, to prevent this happening. That would mean another US$100 billion of government stimulus disappears from the economy each year over the next decade or so, an estimated hit of about 0.5% to GDP in 2013. Obama, sensing the danger of another austerity hit, in early February proposed that Congress pass a US$85 billion package of spending cuts and tax changes to offset the damage the sequester would have for the rest of 2013.

Politician-proof

Austerity can be a sound government response to prevailing economic conditions. Classic Keynesian economics would tell a government to run fiscal surpluses when the economy is humming to keep inflation under control. Austerity is just not optimal policy-making when a country’s export partners are in recession, an economy is recovering from a financial crisis, confidence is fragile and unemployment high. (The composition of austerity matters, too. Policies that hit the richer harder than the poor are less damaging that ones that do the opposite.)

How will the US economy handle austerity in coming years? It’s instructive to note that federal government spending supported the US economy from 2009 to 2012, at a time when many state and local governments were forced by law to slash spending and raise taxes to balance budgets.

Over the same period, the Federal Reserve set interest rates at zero and used unconventional means such as quantitative easing to ensure maximum thrust from monetary policy. The result of these efforts was that after the US economy contracted 3.5% in 2009, it expanded 3% in 2010, 1.6% in 2011 and is expected to have grown 1.3% in 2012. [5]

These numbers suggest the US recovery is sluggish and that it will have trouble coping with austerity shaving 1%-plus off GDP growth.

The US economy, though, may be more resilient than recent numbers suggest. The US government’s overspending is supporting growth, easy monetary policy is virtually assured in coming years and bright spots are emerging across the economy. The most sparkle is coming from housing due to low interest rates – thanks especially to the Federal Reserve’s purchases of mortgage-backed securities as part of its quantitative-easing program.

House prices nationwide rose for the fifth consecutive month in December from a year earlier, while housing starts and new home sales are rising while the number of foreclosures is dropping. Banks are lending more to home buyers, giving builders more confidence to invest in new homes – residential investment surged at an annual pace of 15.3% in the fourth quarter. Home building, which historically has accounted for about 4.5% of US GDP, is expected to make a substantial contribution to economic growth in 2013, an impact that will be magnified because a robust housing market gives home-related industries a boost.

More good news is that big-data technology, cheaper energy from fracking shale and wage restraint have made US manufacturing more competitive. Companies such as Apple and General Electric are shifting production home. A better trade performance due to reduced oil imports thanks to fracking and the weaker US dollar helping exports is expected to add to GDP, even if exports struggled in the fourth quarter.

If consumer and business confidence and jobs growth survive the political dramas, domestic demand is likely to hold up – consumption rose at a 2.2% pace in the fourth quarter while business investment set a 12.4% tempo. The extra 1.84 million people employed in the US over 2012 will add to overall demand. Don’t underestimate how much pent-up demand there is in the US after five sluggish years of growth – the release of pent-up demand is capitalism’s way of triggering self-sustaining recoveries. (There’re only so many years old cars and fridges can keep going.)

Add on the US’ long-term economic advantages – the ability of its citizens to innovate, the country’s large natural resources and mobile population – and the US recovery is more likely than not to withstand the challenges thrown at it by politicians. US stocks at five-year highs suggest investors think this way too.

Perhaps the best perspective to view the antics in Washington is to realise that whether or not the US escapes a recession this year is a sideshow in terms of the biggest risks investors face in 2013. As the US-based Stratfor Global Intelligence says, high unemployment and social discontent in the US will not lead to the disintegration of the republic into 50 countries with their own currencies. [6] Whereas, the damage austerity is wreaking in countries such as Portugal could do just that to the eurozone.

Financial information comes from Bloomberg unless stated otherwise.

Important information

References to specific securities should not be taken as recommendations.

1 The Telegraph. “Portugal warns EU-IMF troika to back off on austerity demands.”
2 Eurostat new release. “Euro indicators. Provision of deficit and debt data for 2011 – second notification.” 22 October 2012. http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-22102012-AP/EN/2-22102012-AP-EN.PDF
3 IMF Working Paper. “Growth forecast errors and fiscal multipliers”. Olivier Blanchard and Daniel Leigh. January 2013. http://www.imf.org/external/pubs/ft/wp/2013/wp1301.pdf
4 European Trade Union Institute. Working papers. “Withdrawal symptoms: an assessment of the austerity packages in Europe. 2011. Table 2, page 14. http://www.etui.org/Publications2/Working-Papers/Withdrawal-symptoms-an-assessment-of-the-austerity-packages-in-Europe
5 IMF. World Economic Outlook. October 2012. Table A1. http://www.imf.org/external/pubs/ft/weo/2012/02/pdf/tables.pdf
6 Stratfor Global Intelligence. “Europe in 2013: a year of decision.” 3 January 2013. http://www.stratfor.com/weekly/europe-2013-year-decision?utm_source=freelist-f&utm_medium=email&utm_campaign=20130103&utm_term=gweekly&utm_content=readmore&elq=f8595d076faa43899a87ff356f78fec

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The scandal emerged in August when the New York State Department of Financial Services accused the “rogue” Standard Chartered of “scheming” for years to skirt US laws when processing US$250 billion worth of transactions on behalf of Iranian clients.

The accusations are the latest in a spate of banking scandals that could undermine London’s role as a global financial hub. Threats to such a critical asset as “the City” serve as a metaphor for the larger troubles the shrinking UK economy confronts in a post-financial-crisis world.

The importance of this for global investors is that the UK comprised about 8% of the MSCI All Country World Index at the end of last month, compared with 14% for the rest of Europe. To put the UK’s challenges into perspective, though, the country is not headed for an IMF bailout as happened in 1976. Record low bond yields show the country is viewed as a haven from the euro crisis. Many of its best companies are world leaders that will prosper, even if hobbled by their homeland’s slow descent.

The banking scandals rank among the UK’s top challenges because they threaten a sector that is the UK’s biggest source of foreign exchange and pays 12% of the country’s tax. Other financial scandals involve proof that the UK’s biggest banks (with foreign help) have rigged widely used benchmarks for years, that UK banks launder money for terrorists and drug lords and that they rip off local customers by mis-selling insurance and improperly selling interest-rate swaps. On top of that, just about every rogue trading arm that torpedoed its parent in recent years was based in London. The list includes the JPMorgan Chase unit that blew US$7 billion, the feral trader who cost UBS US$2 billion and the quant buffs at AIG, Lehman Brothers and Bear Stearns who fatally dabbled in derivatives.

Rogue banks
The rates-fixing scandal broke in June when regulators fined Barclays 290 million pounds (A$440 billion) for fiddling from 2005 to 2009 with the London and Euribor interbank offered rates, the benchmarks for about US$10 trillion in loans and about US$350 trillion in derivatives. The Royal Bank of Scotland and Lloyds Banking face similar accusations that their traders lied on daily surveys about borrowing costs over certain time frames and in different currencies. The Bank of England is tainted because it ignored warnings about the rigging.

Even more explosive, a US Senate investigation in July found that HSBC exposed the US to “a wide array of money laundering, drug trafficking and terrorist-financing risks” by failing to check about US$15 billion (A$14.5 billion) sourced from Mexico, Russia and other money-laundering blackspots from 2006 to 2009. In August, came the accusations that Standard Chartered left the US “vulnerable to terrorists, weapons dealers, drug kingpins and corrupt regimes”. The Royal Bank of Scotland is being investigated for infringing sanctions against Iran.

British banks have a record of violating US laws. In 2010, Barclays paid US$298 to settle claims it dealt with banks from countries under US sanctions such as Cuba, Iran and Libya. A year earlier, Lloyds paid US$350 million to settle claims over dealing with Iranian banks.

These scandals show that the gentle regulation that UK authorities pursued to promote London as a global financial centre has backfired. The government was forced to nationalise or prop up four of the UK’s nine largest banks during the financial chaos triggered by the recklessness it allowed. The wrongdoing threatens London’s role as the world’s forex hub, a global lending headquarters and a derivatives hot spot.

UK politicians are under pressure to toughen regulations on banks, which already confront sluggish earnings, spiralling bad loans and higher funding costs. Stricter rules may spook some of the 250 foreign banks based in London for they will make the City a costlier and more frustrating base. The scandals make it harder for London to ward off European Commission attempts to regulate hedge funds, most of which are based in London, or to block the European parliament’s attempts to cap bonuses to 100% of salary – a ceiling sure to frighten bankers away.

Establishment woes
A second challenge for the UK is that the banking industry is only the latest pillar of national life to be humiliated for corruption and greed. The media and police are mired in the phone-hacking and bribery linked to newspapers from Rupert Murdoch’s News. Politicians are still damaged by allegations in 2009 they had rorted their expenses for years.

More than 340 of the 646 members of the House of Commons were quizzed on irregularities that year and at least four lawmakers were convicted (two going to jail) for fraud. Companies are slammed for their excessive executive salaries and corruption – GlaxoSmithKline, for example, was fined US$3 billion for mis-marketing anti-depressants to children. The Church of England is fractured. It appears that only the public service, the judiciary and the royal family, apart from Prince Harry after his nude frolics in Las Vegas, have escaped disgrace.

The repercussions of the collapse of public faith in institutions are likely to be large over time. Social divisions may widen and anti-establishment parties are likely to impress voters while mainstream parties may pander more to populism, all to the cost of economic efficiency at the very least.

Then there is the threat posed to the UK by the eurozone debt crisis. Well might euro-sceptics in Britain gloat that they warned a monetary system without political union was doomed (even if much of the UK opposition to joining the euro reflected an island mentality). But it’s hard to see how the UK can gain from this crisis, even with its own currency and central bank.

There are only two final outcomes for the eurozone debt crisis; the end of the euro or the fiscal and political integration that saves the currency. A collapse of the eurozone would send countries that take nearly 50% of the UK’s exports into turmoil. While consumer and business confidence would be smashed everywhere and financial systems may freeze, the battering would be bigger the closer a country is to the explosion as commercial and business ties are stronger and confidence linkages greater.

Longer term, though, perhaps a bigger danger to the UK is if the eurozone survives and thrives – and don’t underestimate the will of Continental Europe to preserve the integration that has kept Europe at peace since 1945. London’s attempts to safeguard the UK’s interests threaten grand solutions for the eurozone and are costing the UK political goodwill. Eurozone members feel they are being held to ransom when the UK jangles its veto over fiscal and political steps to unification in exchange for exemptions for the UK on related or unrelated matters.

The 17 members of the eurozone, for example, were upset in December when London tried (but failed) to block an EU-wide fiscal compact unless financial regulations were eased for the City. London is fighting to keep the continent-wide bank supervision powers that EU leaders (including Prime Minister David Cameron) approved in June restricted to the eurozone rather than the 27-member EU.

A more-unified eurozone will most likely work to isolate the UK politically and economically. Any referendum that results in the UK leaving the EU to perhaps become, like Iceland, Liechtenstein and Norway, part of the European Economic Area instead will only fan anti-British feelings in the eurozone.
 
Toxic economics
Another peril to the UK is a self-inflicted punch to its economy, which struggles anyway against perennial government and current-account deficits. For ideological reasons rather than in response to any emergency, Cameron is pursuing austerity policies that in fiscal 2011 and fiscal 2012 are removing government spending worth about 4.75% of GDP – and he expects austerity to last until fiscal 2020. After only one fiscal year, the result is a textbook case of how austerity policies during a downturn make everything worse, even the budget deficit (at 8% of GDP in the UK) and government debt levels (80% of GDP) that such policies seek to correct.

The country is suffering its second recession since the financial crisis started and the jobless rate is above 8%. Output has shrunk 0.9% since the third quarter of 2010 just after Cameron came to power in May that year. GDP is 4.5% below its 2008 peak, meaning the country is on course for a longer depression than it suffered during the 1930s.

The country’s triple-A rating from Moody’s, which placed the UK on negative outlook in February, looks vulnerable.
The IMF warns the side effects of a prolonged downturn will trim the country’s long-term growth potential, a curse known as hysteresis. These consequences include the loss of skills among long-term jobless, the destruction of unused capital and underinvestment preventing innovation.

“(The IMF’s) central scenario assumes that hysteresis effects will lower potential GDP growth by about a third of a percentage point annually on average over the medium term, with other lingering effects of the crisis (e.g., restrained global demand for financial services) taking off another fifth of a percentage point,” the IMF says. It’s likely a political and business backlash will force an end to austerity before such damage is done.

Finally, the UK is structurally handicapped for the 21st century. The country is resources poor, has a political system designed to protect the rich through the unelected House of Lords, has an aging population and its class system means a large percentage of its population is kept under-educated when globalisation makes human capital a country’s greatest long-term asset.

There is hope for the UK, though. The London Olympics lifted the mood of the British, may help the economy expand during the September quarter and showcased one area where the UK is shining; namely sport. The UK team finished third on the medal tally, seven spots ahead of Australia.

While its soccer team is brittle and a Briton still can’t win Wimbledon, one claimed this year’s Tour de France, others have won recent golf majors, England’s cricket team held the world No. 1 ranking for a year until losing it to South Africa in August and its rugby team is the only one from Europe to win a World Cup. If after decades of easy-beat status, the British, with government money and foreign (much Australian) know-how, can win at play, there are no reasons why they can’t use the same sort of formula to conquer at work.

This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 (“Fidelity Australia”).  Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity Worldwide Investment. Prior to making an investment decision, retail investors should seek advice from their financial advisers. Investors should also obtain and consider the Product Disclosure Statements (“PDS”) for any Fidelity fund mentioned in this document. The PDS can be obtained by contacting Fidelity Australia on 1800 119 270 or by downloading from our website at www.fidelity.com.au. This document may include general commentary on market activity, sector trends or other broad-based economic or political conditions that should not be taken as investment advice. Information stated herein about specific securities is subject to change. Any reference to specific securities should not be taken as a recommendation to buy, sell or hold these securities. While the information contained in this document has been prepared with reasonable care, no responsibility or liability is accepted for any errors or omissions or misstatements however caused. This document is intended as general information only. The document may not be reproduced or transmitted without prior written permission of Fidelity Australia. The issuer of Fidelity’s managed investment schemes is FIL Responsible Entity (Australia) Limited ABN 33 148 059 009. Reference to ($) are in Australian dollars unless stated otherwise.  2012 FIL Responsible Entity (Australia) Limited.  Fidelity, Fidelity Worldwide Investment and the Fidelity Worldwide Investment logo and F symbol are trademarks of FIL Limited.

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The new Dodd-Frank Act, which will once again split savings and investment banking in the US, aims to usher in as successful a regulatory regime as the one provided by the Glass-Steagall Act of 1933 until its final, fatal repeal 13 years ago.

But the Wall Street Reform and Consumer Protection Act of 2010, known as Dodd-Frank after its authors Senator Chris Dodd and Congressman Barney Frank, is onerous and flawed lawmaking. It has since been nibbled at by bank lobbyists and is not yet complete – 11 bodies are fleshing out the law’s intent in regulations.

While the biggest overhaul of US finances since the 1930s will provide an employment boost for lawyers and regulators, the law may be too feeble to prevent a systemic collapse. Yet don’t lose heart. The world’s financial system has some things helping keep it in check including a powerful invisible force.

The main aims of Dodd-Frank are to prevent a systemic financial crisis, to control derivatives and to provide a coping mechanism for when a too-big-to-fail financial institution fails. And it does make worthwhile attempts at these goals. Oversight has been consolidated to some extent and many derivatives will now trade on public exchanges, so they will be less opaque and less debt-laced.

The biggest test of the act will be how it copes with the failure of a non-bank whose collapse threatens the financial system such as the demise of Lehman Brothers did. (US policymakers have long been able to handle a failing bank and protect depositors – they have closed more than 445 banks in the past four years with little fuss.) In 2008, authorities only had the bankruptcy process (Lehman’s option) or bailouts for creditors (the solution for AIG) as options when non-bank giants struck trouble. Under Dodd-Frank, authorities can put a non-bank posing a systemic risk in receivership and either sell it or split it into a bad bank and a viable bank, which still operates. In this insolvency process, depositors are supposed to get their money back, shareholders are ruined and creditors accept an appropriate loss. The aim, as always, is to stop a wider run on banks.

One problem is that the new law was written by those who think the US government overstepped its power after Lehman failed in 2008 when Washington provided taxpayer-funded bailouts to save institutions that floundered due to speculation.

The act forbids many of the rescue measures that were adopted four years ago. Banned are company-specific support as was done for companies such as AIG and Citigroup, government help for money-market funds and guarantees on bonds issued by financial firms unless approved by Congress.

One problem is that it’s harder for the Federal Reserve to help sound banks facing a liquidity crisis – a key plank of central banking. Other flaws of the insolvency process under Dodd-Frank are that it makes no allowance for how to treat a US institution’s international assets, it assumes authorities will act pre-emptively and it presupposes that policymakers can formulate an acceptable formula of losses for creditors without sparking wider repercussions. Ultimately, we will only know if Dodd-Frank can cope with a systemic threat when it’s tested.

The Volcker rule

The most renowned part of Dodd-Frank is the contentious Volcker rule, named after former Fed chairman Paul Volcker who pushed for its inclusion. This tenet from next year resurrects the part of Glass-Steagall that bans banks that accept deposits from trading (speculating) with shareholder funds. In other words, it separates commercial and investment banking. The rule aims to stop speculators from gaining access to the taxpayer support that deposit-taking commercial banks enjoy. Authorities want to protect deposit-taking or savings banks (and their lending) from gambles that go awry. The US Government Accountability Office calculates that the six largest US bank holding companies lost nearly US$16 billion on proprietary trading in the 18 months ending December 2008, Bloomberg reports.

The Volcker rule allows savings banks to conduct short-term trades for hedging or market-making, while limiting bank investments in private-equity and hedge funds to 3% of tier-one capital. (Glass-Steagall, in practice, was tougher because it banned speculation and market making and most underwriting.) The new restrictions may limit banks’ trading profits – the pre-2008 source of much bank revenue and large banker bonuses. In response, many big US banks have shut or sold proprietary trading desks or started hedge funds run by their former prop traders.
Bankers are lobbying to weaken a rule that they have two years to comply with because they say it will increase risk, limit liquidity, boost costs for investors, spur gaming and create litigation. JPMorgan Chase’s antics will make their job harder as its CEO Jamie Dimon was one of the strongest advocates of watering down the Volcker rule – he helped create a loophole for “portfolio hedging”, the frolics that cost his bank so much. They won’t stop trying though.

The power of memory

Dodd-Frank has its flaws. Big banks were not broken up, so they still threaten the system if they collapse. Much of the so-called shadow banking system is untouched and the law barely covers Fannie Mae and Freddie Mac, the government-sponsored home-lending agencies that received the largest bailouts in 2008. There is no international insolvency formula in place. Lobbyists are trying to thwart the transparent trading of derivatives. The law imposes costs on banks that will reduce earnings and lending and thereby economic growth. On top of all this, presumptive Republican presidential candidate Mitt Romney wants to repeal the law.

Should we worry about the safety of the US, hence global, financial system? Probably not – for two reasons.

Firstly, the finance industry is offering up enough scandals to shatter its political support, even with all the money thrown at US lawmakers. The billions of dollars lost by JPMorgan Chase’s London-based trading unit is undermining the credibility of those trying to stave off a wider divide between savings and investment banks. The US Senate finding in July that the UK-based HSBC exposed the US to “a wide array of money laundering, drug trafficking and terrorist-financing risks” and similar accusations against Standard Chartered by New York regulators reinforce the lack of ethics among bankers. They perhaps even overshadow for amorality the fraud involving the world’s biggest banks centred around the rigging of the London and Euribor interbank offered rates, which are the benchmarks for about US$10 trillion in personal and commercial loans and about US$350 trillion in derivatives.

These scandals are shaping up as ones that will have devastating political (as well as financial) costs for banks. If they fail to usher in harsher regulatory regimes, it will only take a few more displays of such rottenness to leave banks defenceless against populist calls for rabid regulation. In one of the most telling U-turns among bankers to date, Sandy Weill, the man who championed the repeal of Glass-Steagall so he could forge Citigroup through acquisition, called for big banks to be broken up so that we have a system “that’s not going to risk the taxpayer dollar, that’s not too big to fail”.

Secondly, there is an invisible power policing finance that is more effective than the most draconian and watertight of laws – memory. The greatest force in favour of the smooth running of the world’s financial system is that people remember what recently went wrong and why. While the world is still dealing with the aftermaths of the US sub-prime crisis and financial booby traps planted before 2008 may still explode, it’s likely that bankers will find it harder to misbehave for a while.

Investors, regulators, voters and even bankers acknowledge the malpractices that led to the global financial crisis. So they are mending their ways – if anything, they have overcompensated for their risk taking or laxness.

Within banking, while rogue traders will always exist, compliance departments are more powerful, stricter lending standards are in force and senior management and boards are more suspicious of financial wizardry and trading units somehow earning a fortune, even if not at JPMorgan Chase until it lost billions. Most bankers realise that if there is another financial catastrophe soon their industry will be overregulated for a long time. Regulators are more vigilant and empowered, so much so they risk stifling innovation with their thousands of pages of laws and tougher capital controls. Rating agencies are more conservative with their approvals. Investors are so risk averse they prefer cash and government bonds to higher-yielding equities, let alone something like mortgage-backed derivatives banged together by US investment banks. Most people now understand that home prices can fall. Voters want finance regulated and are wary of free-market ideologies, even if they are electing conservative governments. Free-market zealots will find it harder to be appointed as heads of central banks and, if any are, they would never carry the aura of Alan Greenspan at his most untouchable.

The memory of the economic woes triggered by the US sub-prime lending crisis will linger in the worst-hit countries for generations. The time when proper regulations will be needed will be when people now in their twenties are well retired and their grandchildren are shaping society. After all, it was not until six decades after the Great Depression that bankers were able to convince US lawmakers to ditch Glass-Steagall to allow the marriage of investment and commercial banks, thereby giving utilities – for that’s what savings banks more or less are – the ability to gamble away billions and help trigger a global financial crisis.

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Singh’s alliance has since cracked under corruption scandals. The results of recent state elections will only make it harder for him to unify his political partners and push through the reforms that India’s slowing economy needs.

The results of month-long elections showed that the Congress party performed poorly in three of the five state polls. The most disappointing result was in northern state of Uttar Pradesh, India’s most populous state that, as home to more than 200 million people, is considered to be the political battleground state. Congress was banking on boosting its holding of 22 seats in the 403-seat assembly to at least 80 seats to enable it to form a coalition at state level with the socialist Samajwadi Party so it could cement this party’s support at federal level.

Even though Congress’ bid for power was headed by Rahul Gandhi of the Nehru-Gandhi dynasty that has dominated Indian politics since independence in 1947, the Samajwadi Party won a comfortable majority in the state from the tainted Bahujan Sarnaj Party (whose leader is fond of building statues of herself) – gaining at least 220 of the 403 seats. Congress only won at least 28 seats, to come fourth in a state that sends most MPs to the Lok Sabha, as India’s lower house of parliament is called.

The result follows a bleak 2011 for Congress at a national level and portends poorly for the next general elections in 2014, especially now its hoped-for prime minister Gandhi failed to win over voters. Numerous corruption scandals over the past 12 months or so have scuttled the government’s reform drive as smaller coalition partners have splintered off and thwarted any significant changes.

The most glaring reform defeat was Congress’ announcement last year that India would allow foreign department store owners such as Walmart to set up in India. This decision, which didn’t require the passing of any laws, was overturned within days after Congress’ coalition partners, opposition parties and state governments objected to a move that is seen as threatening the family-run stores prevalent throughout India. Other stalled reforms include attempts to clarify land acquisition, strengthen anti-corruption measures and overhaul insurance and investment management.

Investor verdict
Congress was hoping that a strong performance across the five states would pressure its rebelling federal coalition partners or prompt its outside supporters such as the Samajwadi Party to push on with reforms. Better results may have also improved the morale and determination of Singh’s rattled-looking government.

Even if a Congress-led coalition holds onto power in 2014 (and Congress has ruled India for most of the post-independence era), it’s now more likely to be a far more unwieldy coalition than the one that so excited investors in 2009. The Congress-led coalition that ruled India from 2004 to 2009 was a disjointed coalition that included Communist MPs.

Investors were disappointed with the state election results. “We view the election results as negative for economic reforms and the markets, though a key uncertainty has been lifted,” said Goldman Sachs in a report on the election.  “We think the results will not provide the political space for the government or the confidence to carry through unpopular reforms.”

Congress did win a majority in the northeastern state of Manipur and in the Himalayan state of Uttarakhand, but it fizzled in the northern state of Punjab (won by the incumbent alliance of the Shrimoni Akali Dal and Hindu-based Bharatiya Janata Party) and in the western state of Goa (won from Congress by the Bharatiya Janata Party).

Congress has much work to do to spark another rally in shares.

 This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 (“Fidelity Australia”).  Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity Worldwide Investment. This document is intended for use by advisers and wholesale investors. Retail investors should not rely on any information in this document without first seeking advice from their financial adviser. This document has been prepared without taking into account your objectives, financial situation or needs.  You should consider these matters before acting on the information.  You also should consider the Product Disclosure Statements (“PDS”) for respective Fidelity products before making a decision whether to acquire or hold the product.  The relevant PDS can be obtained by contacting Fidelity Australia on 1800 119 270 or by downloading from our website at www.fidelity.com.au. The issuer of Fidelity’s managed investment schemes is FIL Responsible Entity (Australia) Limited ABN 33 148 059 009. Details about Fidelity Australia’s provision of financial services to retail clients are set out in our Financial Services Guide, a copy of which can be downloaded from our website at www.fidelity.com.au. © 2012 FIL Responsible Entity (Australia) Limited. Fidelity, Fidelity Worldwide Investment and the Fidelity Worldwide Investment logo and F symbol are trademarks of FIL Limited.

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Many of Asia’s biggest stock markets had a poor 2011. That helped to make the steady performance of the four emerging ASEAN countries in the MSCI Asia ex-Japan Index even more remarkable.

Stock benchmarks in the Philippines, Indonesia and Malaysia rose 4.1%. 3.2% and 0.8% respectively last year while Thailand’s only edged down 0.8%, even though the country suffered its worst flooding in nearly 70 years. These four countries plus Brunei, Cambodia, Laos, Myanmar, Singapore and Vietnam comprise the 10 members of the Association of Southeast Asian Nations.

Singapore, which is classed as a developed market, is the only other ASEAN member in the regional index. Even though Singapore’s Straits Times Index sagged 17% last year, the performance of the island’s four emerging neighbours meant that ASEAN markets last year outperformed the MSCI Asia ex-Japan Index for the fourth straight year.

Like Singapore’s, the other five markets in the MSCI Asia ex-Japan Index struggled last year. Equity benchmarks in India, China, Taiwan, Hong Kong and Korea slumped 25%, 22%, 21%, 20% and 11% respectively in 2011.

Singapore and the five non-ASEAN stock markets drooped as authorities battled inflation by tightening monetary policy and their major export markets of Europe and the US struggled under sovereign debt concerns. These six countries comprised 87% of the MSCI Asia ex-Japan Index on 31 December 2011. That explains why over 2011 the Asia benchmark fell 17% in US dollars and the same amount in Australian currency.

The Philippines, Indonesia, Malaysia and Thailand fared better because reforms enacted after the Asia crisis of 1997-98 have stabilised their economies, inflation is largely under control, these economies are more driven by domestic demand, and authorities are insulating their countries from global concerns. Central banks in Indonesia and Thailand have cut interest rates in recent months and governments in all four capitals are implementing fiscal stimulus. Thanks to these measures, ASEAN economies are expected to grow between 3% and 5% in 2012.

Evidence of the improved economic fundamentals of these four ASEAN economies include how government and household debt are low relative to GDP. Indonesia, for instance, has reduced government debt from 47% of GDP in 2005 to 26.1% by June last year, while household debt in Thailand is only at 27% of GDP.

As trade among ASEAN nations sets fresh records, these four countries are running current-account surpluses – Malaysia’s is 12.3% of GDP – and have doubled, tripled or quadrupled their forex reserves in the past five years. The Philippines’ forex reserves, for example, climbed from US$19 billion in 2005 to US$75 billion by September last year.

Importantly for stock investors, corporate balance sheets are just as healthy, earnings are growing and valuations are attractive on these ASEAN markets.

For a fifth year?
The Philippines hosted Asia’s strongest-performing bourse in 2011 after Fitch, Moody’s and S&P lifted their credit ratings or outlooks closer to investment grade due to the country’s stable economy and improved government finances. Inflation ended the year below 5% while the economy is expanding at a 3% clip with spending stimulus to come.

Indonesian stocks came second for the year, after being Asia’s best performers in 2010 and 2009. During the past 12 months, Indonesia regained its investment-grade credit rating after a 14-year lapse, the central bank cut rates twice to support growth and a law was passed that allows the government to acquire the land needed to create the infrastructure the country lacks.

Malaysian stocks posted their third straight year of gains, the first time they have done so since 1993, thanks to the defensive nature of the country’s largest stocks. The government is preparing fiscal stimulus to protect economic growth running at a 6% annual pace while inflation remains under control at just over 3%.

Thailand stocks withstood the floods that killed more than 600 people and wrought more than US$10 billion in damages. Rate cuts, government financial aid and rebuilding are expected to help the economy recover by the second quarter of this year and grow about 5% in 2012.

While challenges lurk, emerging ASEAN markets could easily outperform the regional benchmark for a fifth consecutive year in 2012, while again offering positive returns.

Financial information comes from JPMorgan and Bloomberg unless otherwise stated.
1 Bank of America Merrill Lynch. “ASEAN 2012: Buy superior & quality growth.” 9 December 2011
2 Morgan Stanley. “ASEAN Economics. Navigating the 2012 global slowdown.” November 2011
3 Bank of America Merrill Lynch. Op cit.

This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 (“Fidelity Australia”).  Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity Worldwide Investment. This document is intended for use by advisers and wholesale investors. Retail investors should not rely on any information in this document without first seeking advice from their financial adviser. This document has been prepared without taking into account your objectives, financial situation or needs.  You should consider these matters before acting on the information.  You also should consider the Product Disclosure Statements (“PDS”) for respective Fidelity products before making a decision whether to acquire or hold the product.  The relevant PDS can be obtained by contacting Fidelity Australia on 1800 119 270 or by downloading from our website at www.fidelity.com.au. The issuer of Fidelity’s managed investment schemes is FIL Responsible Entity (Australia) Limited ABN 33 148 059 009. Details about Fidelity Australia’s provision of financial services to retail clients are set out in our Financial Services Guide, a copy of which can be downloaded from our website at www.fidelity.com.au. © 2012 FIL Responsible Entity (Australia) Limited. Fidelity, Fidelity Worldwide Investment and the Fidelity Worldwide Investment logo and F symbol are trademarks of FIL Limited.

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