Country risk September 2006: The repercussions of oil and conflict


Paul Pedzinksi, Florian Neuhof
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The latest country risk poll reflects a global economy in good health, despite a period of stock market volatility and the prospect of a slowdown. But the Middle East and the high price of oil could have far-reaching implications, writes Florian Neuhof. Research by Paul Pedzinski.

For historical country risk data please visit the Euromoney Country risk website
Oil and the region that produces it continue to be a source of instability.
Country risk: Methodology

THE LEBANON CRISIS has once again focused the world’s attention on the Middle East, but it came too late to have had a dramatic impact on Euromoney’s latest country risk poll. Israel dropped by only two places in the rankings, from 38 in March to 40 in September, for example. Lebanon went down to 106 from 98, but such fluctuations are not unusual at the lower end of the spectrum. As the region has become accustomed to turbulence, rankings have remained relatively stable throughout; only Iran has shown a steady trend since last September, its ranking falling from 73 to 89.

Middle East rankings in this respect mirror the risk premium that is added to the price of oil. They reflect the dangers and instability of the region, which have a long-term detrimental effect on both ranking and oil price. “Middle East tension is an obvious contributor to the risk premium on oil. The market has already priced this in, and the current situation will keep prices from softening,” says Robert Kelly, CEO of CountryWatch. So, although the conflict in Lebanon has not increased oil prices significantly, it is also doubtful whether or not it will undermine rankings in the region on the whole.

But this is dependent on the crisis being prevented from spreading throughout the region. “The UN Resolution 1701 that was passed to establish a ceasefire between Israel and Hizbullah has tried to put a lid on the conflict before the regional ramifications become more serious,” says Nadim Shehadi, associate fellow at Chatham House, referring to the underlying tensions between Iran, Syria and the US. There is potential for escalation, with Israel already having voiced the possibility of military action to forestall Iran’s nuclear programme. The Bush administration has also been studying options for military strikes against Iran as part of a broader strategy of coercive diplomacy.

As Iran faces pressure to comply with the UN resolution on discontinuing its program of uranium enrichment, Shehadi thinks it is possible that it could make use of its links to Hizbullah to deflect attention. It is also within its means to stoke an insurrection among the Shias in southern Iraq. Simon Sole, CEO of Exclusive Analysis, agrees: “Iran could respond to pressure by using its influence to promote insurrection in Iraq.”

Kelly is more sanguine about the outcome of the uranium enrichment stand-off. “The way things are going, Iran will not want to stir up an uprising in southern Iraq. If the deadline [on Aug 31] is not observed, the US will push for sanctions, to which Iran might respond with the oil weapon.” Kelly believes that the risk premium included in oil prices would prevent prices from rising in the short term. But eventually the consequences would become evident. “The oil market is tight – if Iran pulls the plug that could have an impact on prices in the medium term,” says Kelly.


A major upheaval that leads to a decrease in oil supply could have repercussions elsewhere. China, with its insatiable energy demand, could suffer from an uncomfortable knock-on effect. “An escalation in the Middle East would have a negative impact,” says Peter Morgan, chief economist of the Asia Pacific region at HSBC. “But it is hard to say when the tipping point is going to be. People have been amazed at how well the economy has held up, in view of high energy prices, but this has probably to do with the fact that oil prices have so far been driven by demand, not supply.”

Kelly agrees. “Any major restriction on oil supplies would be a slowing factor,” he says. However, Kelly does not believe that energy shortages could stall the Chinese economy in the long term. “In my view, China will do what it takes to grow,” he says, reflecting the confidence that observers place in Chinese growth prospects. Kelly points to the efforts of the Chinese government to convert its coal reserves, the world’s third largest, into liquid fuel.

At the moment, country risk in China and Asia as a whole is not a hot topic. Most countries are running on a current account surplus, and are keen to raise foreign currency reserves.

Nevertheless, “there are some icebergs out there that need to be watched,” as Kelly puts it. Kate Davies, managing economist at D&B, points to several sectors in China that are overheating. “GDP growth in real terms was 11.3% in Q2 on the previous year,” she says. “That’s not sustainable. Growth will eventually have to cool down. There’s been some consolidation in steel but it’s still overheated. Chemicals, non-ferrous metals, automobiles, real estate and construction are also potentially severely over-invested sectors.”

So far, little has been done to slow growth. This might have to do with the decentralized nature of the economy. “Local governments are countermanding central government directives to restrain new lending and ordering state banks to lend to prestige and employment-generating projects,” says Davis. Morgan points to strong vested interests on the part of big companies, and believes that the idea of maximum employment is still strong. “The government has proven in the past that it can tighten rates if it wants to. It is striking that is has not done that,” says Morgan. “It doesn’t seem too concerned about overheating.” And if official inflation figures, which put inflation at around 1.5%, are to be believed, then prices are under control.

Non-performing loans are potential pitfalls. These remain of major concern in China, despite Ernst & Young having to withdraw claims that the volume could be as high as $900 billion in May. As Morgan points out, as long as GDP growth is strong, companies can service their debts, and credit growth can be catered for. But the authorities’ hands might be tied in trying to curtail this growth. “If the government cracks down on credit growth it might kick off a slowdown, which would in turn make NPLs problematic.”

A substantial crisis in the Middle East, or elsewhere, that led to a sharp rise in energy costs might also bring the NPL problem to tipping point. “Oil prices in the region of $100 a barrel would be a shock across the board, and might make NPLs a real issue in China,” says Morgan.

Latin America

As major exporters of commodities to China, Latin American countries could be affected by a downturn in China’s economic fortunes, and this is one of the main risks to the region’s positive outlook, according to a Fitch review. Conversely, the region has profited from high demand in its commodities, and improving macroeconomic fundamentals.

With a series of elections coming up, a rather staid country risk picture might liven up. In this year’s poll, significant shifts are evident in the case of Uruguay, a country recovering from a severe debt crisis. Ranking 143 last September, it is showing strong improvement by climbing up to 84. Belize, weighted down by debt, has dropped from 94 to 135 within a year. Much-maligned Venezuela has climbed from 110 to 98, mistrust in its political leadership being offset by the ability to service its debt with oil revenues.

Argentina remains a talking point, with many observers not convinced by the sustainability of its recovery, and with its performance as a reliable borrower, despite scaling the ranks from 120 to 100 since last September. Davies says: “I expect moderating global demand to cause externally driven growth in Argentina to slow, which would probably be the starting point for an end to the dynamic rates of growth seen since the recovery. This may not result in a crisis in the near term or even in the medium term that was as deep as that experienced in 2001, but it will certainly make underlying problems in the Argentine economy more pronounced and the economy will probably enter into a period of lower growth or recession.”

Philip Siegrist, economist at LGT, also has reservations. “After the traumatic debt restructuring in 2005, Argentina’s reputation as a good debtor still has to be rebuilt,” he says. Others are less critical. “Since the rescheduling of Argentina’s debt a year ago, its bonds have performed well. Inflation in the country is low and the interest rates have come down. There is no reason not too see Argentina as a stable partner in the capital markets,” says Conrad Schuler, country analyst at Erste Bank, echoing optimism about the basis of the country’s upward trend in the rankings.

Some of the outstanding elections in the region might prove to have a detrimental effect. In Mexico, Felipe Calderón will almost certainly be declared official winner of a hotly contested election by the electoral commission in early September, but his government will lack a clear majority. “I don’t see a strong prospects for reform early on when Calderón should have the most political capital,” says Davies. This puts at risk the long-awaited labour market and tax reforms. Davies points out that the election in Bolivia provides strong congressional backing for reforms aimed at improving social wellbeing, which will probably be damaging to the business environment, while the same will apply to Venezuela once elections have taken place in December.

Risk levels in central and eastern Europe have shown little volatility, with an overall upwards trend visible, a testimony to the improving macroeconomic fundamentals of the emerging markets. Bosnia-Herzegovina shows the steepest rise in the poll, improving from 125 to 105 since last year.

Perhaps surprisingly, the slump in the stock markets in May, which led to a withdrawal of liquidity from the emerging markets, has not been reflected in the poll rankings of the worst affected, Hungary and Turkey. Hungary’s struggle to reduce its budget deficit and implement structural reforms are old news, and Turkey’s progress in curbing inflation has been noted with approval. The fact that these countries were affected more than others is also simply the result of their larger exposure to international investors. Both countries do remain vulnerable to a global slowdown, however.

Russia has been benefiting from a windfall in oil and gas revenues. But an over-reliance on natural resources poses the real danger of Dutch disease, retarding growth of alternative sectors and making exposing the country to volatility in hydrocarbon prices. Although government data puts the contribution of the hydrocarbons sector to GDP at 11% in 2005, the OECD has suggested that the actual figure could be more than 50%. Standard & Poor’s warns that the government must not be tempted into adopting a loose fiscal policy, and must foster the investment climate to avoid vulnerability towards energy price shifts. Although a drop in energy prices seems unlikely in the near term, the reliance on natural resources has not gone unnoticed: “Russia is already suffering from Dutch disease,” says Gregor Eder, senior economist at Dresdner Bank. “Sixty percent of its exports are in oil and gas; the rouble is strong despite high inflation. They are vulnerable to shifts in commodity prices. Nevertheless, such shifts would not increase country risk in the short to medium term because of the foreign currency reserves they have built up over the years.”

Reliance on Russian energy is already causing problems to some of its neighbours. The Ukraine especially is vulnerable to the commodity price increases it has experienced recently. Its economy is driven by energy-intensive steel and chemicals production. So far, the Ukrainian economy has been spared the bankruptcy of a major producer. But Olena Bilan, analyst at Dragon Capital, points to the continued vulnerability: “If oil prices would increase, say, two-fold, many chemical companies would not be able to survive. Energy makes up 70% of their production costs.”

Whether on the demand or on the supply side, commodities remain the crucial factor in the game of county risk.

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