Summary of the presentation made by Dr. Thierry Apoteker, Managing Director of TAC, at the MASSA Tea Talk on 13 October 2009.
Recent economic indicators confirmed TAC’s scenario of a trough in 2009Q2, and some equity as well as commodity markets are now pricing a V-shaped recovery. TAC believes however that the specific nature of the crisis will leave ‘original scars’ that will prevent a sharp rebound in mature economies. Some of the most positive views today are related to the idea that a major “decoupling” is taking place between emerging and developed economies. Actual developments and the most plausible outlook, suggest that the ability of emerging economies to go back to the pre-crisis levels of economic growth will be very difficult, and that the “decoupling” is taking place only to a limited extent.

In such uncertain economic times, it is useful to remember that risk materialisation has a stronger probability during the immediate exit of crises, and that therefore country risk monitoring is a must for the coming quarters and years.

The worldwide economic recovery is under way, and the probability of a major “double-dip” is low.
Indeed, the wholesale liquidity markets have moved back to normal, enabling the progressive reduction in the indiscriminate credit crunch that prevailed during 2008Q4 and 2009Q1. The impact of the massive policy stimulus (major fiscal swings with large deficits, very low interest rates and ample liquidity injections by central banks) have allowed industrialised countries to avoid the worst of the recessionary forces unleashed after the Lehman collapse in September 2008.

All major industrialised areas have indeed moved back to zero or positive economic growth in the last quarters (e.g. US GDP growing at 3.5% in annualised quarter-on-quarter growth in 2009Q3), and the trough of the crisis was reached in 2009Q2. Added to the traditional inventory cycle, this should allow sufficient strength in final demand to avoid a large double-dip after the current cyclical phase.

However, the speed of recovery will be limited and any sign of a V-shape cycle should be treated with great caution. Indeed, consumer confidence is not improving significantly any more, in part because of the lagged effect of the economic recession on employment; credit distribution will be structurally constrained by the stronger regulation that is expected after the crisis and because households will try to strengthen their balance sheet after the large losses on the value of their assets; and governments will have to initiate the required corrective measures on budget deficit, with a negative implication on the medium-term trend in final demand. Overall, industrialised countries are not expected to move back to their potential levels of economic growth before 2011 – 2012 at the earliest, implying average annual GDP growth below 2.5% in the US, below 2.0% in the Eurozone, and below 1.5% in Japan for the next two years.

During this medium-term period, the risk that is today underestimated is related to inflation: the pick-up in commodity prices after the slump of 2008Q4 – 2009Q1 is creating a push-factor in inflation, while the fiscal and monetary policies are clearly favouring a reversal in long-term inflation expectations. In the very short-term, risks are mitigated by the large output gap, even though the “statistical base effect” is likely to push headline figures above what is currently expected, around the turn of the year or in the first part of 2009.

Emerging markets will remain more dynamic, but their ability to fully decouple is limited.
The impact of the global crisis has been very uneven for emerging and developing nations. China has engineered a major policy-led reversal in economic activity after the first quarter of 2009, and has pulled a number of other emerging markets with her. Similarly, some countries in Latin America (e.g. Brazil or even Argentina) have managed to smooth the impact through efficient policy measures. Commodity and oil exporters have regained some momentum with the pick-up in prices since 2009Q2. Overall, however, the global group of developing countries is registering a large economic slowdown, and the parallelism between their average growth and that of industrialised countries remains constant. This still means that this group of countries will register a positive average GDP growth in 2009, while industrialised countries are clearly in a recession. Accounting today for less than 35% of world GDP and having industrialised countries absorbing two-thirds of their exports, developing countries are not yet in a position to develop a fully autonomous growth cycle and the decoupling remains limited in magnitude and localised (stronger in Asia, impossible in Eastern Europe, for instance).

Country risk analysis is critical during these uncertain times, and allows companies to benefit from the recovery while avoiding major “risk traps”.
TAC has developed a very comprehensive system of quantitative tools providing early warning signals and risk ratings for 70 developing countries worldwide. The models designed incorporate the most sophisticated non-linear statistical tools, and have consistently delivered better and earlier signals that other information available on the market today.

These non-linear models allow computing Economic & Financial Risk Ratings, fundamentally measuring the risks of currency depreciation, cross-border payment problems and cyclical reversal or negative economic growth prospects, with three different time horizons (less than 1 year, 1 to 3 years and 3 to 5 years). In parallel, TAC uses World Bank information on political and governance variables to compute a Political Risk Rating, measuring both the risks of political instability and the issues related to governance, rule of law or regulatory quality.

A simple and easy-to-read way of looking at country risk today is therefore to look at both TAC average Economic & Financial Risk Rating and TAC Political Risk Rating. All TAC measures range from 0 (lowest risk, best situation) to 100 (highest risk, very perilous situation), with the level of 60 being a threshold for substantial risk, while conversely the level of 40 is the threshold with a limited/low risk.

MASSA Tea Talk By Dr. Thierry Apoteker Of Tac on 13 October 2009

The chart below shows the performances of a sample of large developing countries regarding these two fundamental elements of risks. It can be used to separate four different groups of countries:

• On the bottom-left area of the chart are countries that have a moderate degree of risk for both economic and political ratings; the ability to exit the recovery swiftly, to avoid currency depreciation pressures and to pursue reasonable economic policies is stronger than elsewhere. Chile, South Korea and to a certain extent the Czech Republic, Poland, South Africa and Malaysia are in this group.
• Countries that are at the bottom-right side of the chart combine a positive Economic & Financial Risk with larger uncertainties about political and regulatory environment: these countries are likely to recover from the crisis and offer attractive opportunities, but the contractual details and the risks of having government interference or legal difficulties when problems arise should be considered with caution: this is particularly true for Russia, but also to a certain extent for Indonesia, the Philippines, Thailand and China. India, Mexico and Argentina also exhibit similar characteristics.
• Finally, there are emerging countries that have an intermediate level of political risk, but suffer from much larger uncertainties regarding their economic and financial situations. Such countries, including Turkey, Romania, Hungary, and, to a lesser extent, Brazil, may experience more volatility (exchange rates, available liquidity and credit, domestic demand momentum) over the next few quarters.