Perspectives January 2015

MacroResearchGroup

MacroResearchGroup

Contents4 Contributors6 An Introduction to the Macro Research Group

7 The Chinese Economy 8 - Chinese Renmimbi: Internationalisation without Liberalisation Helen Liu

14 - Chinese Dream: The Opportunities and Challenges of the One Belt, One Road Strategy Wenchen Chu

17 Emerging Economies 18 - Emerging Markets 2025 Agne Stengeryte and

Matthew Pennill

23 Advanced Economies 24 - Abenomics 2.0: Will Japan Make or Break? Casey Chan 30 - European Outlook: 2015 and Beyond Navreen Sandhu

33 Market Analysis 34 - Leveraged Finance in 2015: Higher Risk Returns to High

Yield Debt Alex Scott

38 - Is the Automotive Industry on the Road to Recovery?

Anna Steiner and Ben Durant

41 Central Banking and Monetary Policy 42 - Quantitative Easing: Short-Term Solution or Long-Term

Menace? James ORourke

46 - Go Your Own Way: Post-Crisis Financial Regulatory

Reform in the US and the UK Matthew Pennill3 Perspectives

Contributors

Casey is a first year BSc Accounting and Finance student who hopes on entering the fields of investment consultancy or economic research. His research interests include Supply-side Economics, Financial Economics, International Political Economy and Environmental Economics

Casey Chan c.a.chan@lse.ac.uk

Wenchen is an MSc Management and Strategy student. He would like to work as an equity analyst preferably in buy-side companies after graduation. His research interests include Behavioural Economics, Asset Pricing and Game Theory.

Wenchen Chu w.chu1@lse.ac.uk

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James is a second year BSc Economics student, and hopes to continue onto a Masters programme upon completing his undergraduate degree. Born in Italy, James has a particular interest in the economics of Europe and in particular monetary policy, with a special focus on quantitative easing. In the future, James hopes to work in an economics related field.

James ORourke orourkej@lse.ac.uk

Ben is a recent graduate from the LSEs BSc Management programme. He is interested in applying his business knowledge in the technology sector. In his current internship working as part of the web team at the LSE, he works to provide solutions to different groups across the university.

Ben Durant b.t.durant@lse.ac.uk

Helen is a second year BSc Economics student. She is hoping to pursue a Masters in Economics after completing her undergraduate degree. Her research interests include Monetary Economics, Developmental Economics and international Economic History. Outside of academia, she has a passion for music as a pianist.

Helen Liu y.liu80@lse.ac.uk

Agne is a final year BSc Accounting and Finance student. After finishing the LSE she is joining an Interest Rate Strategy desk as a Graduate Analyst. Agne also hopes to return to academia in a few years time in order to complete a Masters in Risk and Finance. She is particularly interested in developments in CEEMEA economies.

Alex is a first year BSc Statistics with Finance student. Once he graduates he hopes to work in financial or economic research. His research interests include Financial Economics, International Trade, Monetary Economics, Business and Credit Cycle Theories, and Macroeconomic and Financial Stabilisation Policy.

Alex Scott a.j.scott@lse.ac.uk

Anna is a final year BSc Management student. After graduating from the LSE, Anna is looking forward to working for a leading primary research firm, where she can leverage her language and networking skills. As well as becoming a successful researcher, Anna is keen to carry on broadening her horizons both through her work and by studying for a Masters programme.

Anna Steiner, Co-Director a.k.steiner@lse.ac.uk

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Navreen is a second year BSc Economics student. She is hoping to complete a Masters and PhD in Economics, and would eventually hope to end up in central banking or research. She is particularly interested in Monetary Policy and its implications.

Navreen Sandhu n.k.sandhu@lse.ac.uk

Agne Stengeryte a.stengeryte@lse.ac.uk

Matthew is a final year BSc Government and Economics student. He is hoping to complete a Masters in Economics after graduating from the LSE, and in the long-term he would like to work in either economic policymaking or economic research. His research interests include Monetary Economics, Business Cycle Theories, Macroeconomic and Financial Stabilization Policy, Behavioural Economics, Decision Theory, Rational Choice Theory, and Political Economy.

Matthew Pennill, Director m.pennill@lse.ac.uk

An Introduction to theMacro Research Group

The Macro Research Group is a new division within the Investment Society, founded in September 2014. Over the past three months we have been producing weekly bulletins, which have analyzed the macroeconomic forces driving markets and offered views on potential market opportunities.

To start 2015, we have launched this new, flagship publication, Perspectives. Inside this journal you will find thorough analysis of a wide range of topical economic stories and structural macroeconomic trends, including an analysis of the internationalisation of the Renmimbi, a look at leveraged finance in 2015, and a view on the future of the Eurozone.

By analyzing key macroeconomic themes and trends, from central bank reaction functions to geopolitical risks, we hope to provide an insight into the future directions markets might take. While top-down analysis of this sort is rarely if ever sufficient in isolation, we believe it to be a vital ingredient in the recipe for good investment.

As this is a new project, we are keen to continue finding ways that we can improve our publications. If you have any comments or suggestions for improvement, we would welcome you sending them to the below email address. Similarly, if you would like to find out more about the group or how you might be able to get involved, please feel free to email us.

We hope you enjoy reading Perspectives!

Matthew Pennill

Founder and Director, Macro Research Group

m.pennill@lse.ac.uk

January 2015

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www.investmentsociety.co.uk/macro-research-group

MacroResearchGroup

THE CHINESEECONOMY

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InternationalisationWithout Liberalisation

Introduction

Efforts to encourage cross-border use of the Renminbi (RMB) picked up speed in the aftermath of the global financial crisis. The use of the RMB in trade settlement has expanded exponentially while RMB-denominated deposits and financial instruments have been growing steadily. With stable output growth and carefully controlled inflation, China may seem to be well-equipped for the take-off of RMB internationalisation. However, is macroeconomic stability sufficient for any economy to internationalise its currency? If internationalisation of the RMB were to be successful, what difference would it make to the global economy? This article consists of seven subsections, discussing prerequisites, recent progress and the future potential of RMB internationalisation.

I. Racing against the Fed? Chinas recent progress vs. the Feds in 1920s

After launching its ambitious cross-border trade RMB settlement pilot project in 2008, China has been actively promoting use of the RMB and the development of RMB financial services. RMB cross-border trade settlement expanded from less than RMB 50 billion in August 2010 to almost RMB 200 billion in September 2011, supporting rapid growth in RMB deposits in Hong Kong SAR, which reached over RMB 600 billion in October, 20111. As of 2014, the RMB is the seventh most traded currency in the world2. Chinas progress may seem ambitious. However, was the pace of internationalisation for the US dollar, currently the most traded currency any steadier? The US embarked on a journey to transform the dollar into an international currency in barely 10 years in the 1920s by establishing the Federal Reserve to ensure a liquid market and stable prices, and to actively promote foreign central banks and governments to hold the U.S. dollar as part of their foreign exchange reserves3.

On the surface then, China might have caught up with the speed of the US in establishing global presence for

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RMB at the early stage of internationalisation. Both the Federal Reserve and the Peoples Bank of China were committed to supporting offshore developments of commercial banks. However, do they function in a similar way? The Federal Reserve is a central bank with the independence and autonomy needed to make credible commitments and gain the confidence of international investors. Would foreign investors value the Chinese central banks credibility purely based on its achievements comparable to the Feds in the 1920s? The next section explains.

II Credibility of Peoples Bank of China

Chairman of the Federal Reserve Alan Greenspan once joked, If you understood what I said, I must have misspoken. Accordingly, one article from The Economist remarked that, the motto for the Peoples Bank of China (PBOC) should be: If you know what we did, we must have done it wrong, for its rarity in making public announcements prior to its actions4.

PBOCs failure to communicate effectively with the public has already triggered instability in the Chinese economy5. Monetary policy in China has often been viewed as prudent6 over the past four years. However, the central bank is widely reported to have injected as much as 1.8 trillion yuan ($294 billion) to prop up the slowing economy through a mix of targeted liquidity facilities since June, 20147. But only in early November 2014, half a year after triggering dramatic fluctuations in the Chinese stock market generated by speculations about its policy changes, did the central bank provide some partial confirmation of its actions8.The failure to explain what it is doing at the right time weakens the central banks effectiveness. A growth rate below 8 %9 and an inflation rate at around 3%10 would have justified quantitative easing. But, the purpose of it is not only to pump money into the economy, but also to improve confidence amongst companies and consumers by removing uncertainty about sufficient liquidity circulating in the economy.

In this article, Helen Liu analyses efforts by the Chinese authorities to promote the Renmimbi in international markets and discusses the implications of further Renmimbi

internationalisation for global financial markets.

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Though the PBOC has been actively providing liquidity to support offshore expansion of commercial banks, Chinas central bank has not yet been able to communicate effectively with agents that would be affected by its policy. There will be time lags before monetary policy affects spending and saving decisions, but the overall effect of monetary policy will be more rapid if it is credible and effectively communicated. In the case of the PBOC, speculation was raised long before its announcement for quantitative easing, which was made after the policy had been applied. Thus, it has been functioning in a way that has failed its intention of applying expansionary monetary policy in the domestic economy. With its actions centred on decisions of the central planning government, PBOCs credibility as a future global liquidity provider is likely to remain weak until it gradually gains autonomy and independence to gain confidence from both domestic and international investors.

III Macroeconomic stability & financial development

International demand for the RMB clearly exists due to Chinas central role within the Asian supply chain and its role as the second largest exporter in the world. The sheer volume of its foreign trade and inward foreign investment creates a large existing base for RMB-based transactions and provides the breadth of the trade network which determined demand for the currency

as a unit of account and store of value. Though Chinas growth rate is likely to decline over the next decade, due if nothing else to a shrinking labour force and aging population, China can still realistically be expected to sustain a growth rate of 7%11 and along with careful inflation control, Chinas investment-grade sovereign credit rating, currently at AA-, also supports the ongoing progress of RMB internationalisation compared to other emerging market economies12.

With projected macroeconomic stability and active development of offshore financial instruments, further financial development within the Chinese economy would be the next step to becoming better equipped for RMB internationalisation. The higher the degree of financial development, the wider the availability of financial services that allows the diversification of risk. Thus restructuring institutions that lead to effective financial intermediation, meanwhile improving access to capital and financial services would support RMB to gain its international credibility enormously.

In the Financial Development Report produced by World Economic Forum in 2012, the Financial Development Index is used to provide a score and rank for the breadth, depth, and efficiency of 62 of the worlds leading financial systems and capital markets. China has not yet joined the top 10 list (see table for Top10 in overall index ranking) in the overall ranking of financial development measured by this parameter13. However, if it continues to carry out policies that support financial

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development, China would hopefully attenuate its need for foreign reserve accumulation, which would help China to reduce its dependence on the US economy by reducing its currently large dollar reserve. It is also likely to allow the Chinese economy to confer stability benefits and limit fluctuations in asset prices which would eventually support China to enhance its credibility in the global monetary system.

IV RMB denominated Financial Instruments Development & Performance

Cross-border Trade Settlement & RMB Deposits

Since its establishment in 2009, the scheme has gradually expanded to include more eligible Chinese companies and locations where trading partners are domiciled. All remaining restrictions on exporters were lifted in August of 2011, opening the gates for any Chinese exporter or importer to transact globally in RMB14. Consequently, the market witnessed stronger and more widespread acceptance of RMB both as a trade and a payment currency after the lifting of restrictions. The Cross-border RMB Index released by Bank of China has more than doubled from 100 points in 2011 to 228 points in 201215.

Fuelled by these vibrant cross-border trading activities and the ensuing trading surplus, excess RMB liquidity accumulated rapidly, leading to the birth of the RMB deposit market in Hong Kong. When the scheme was liberalized in 2011 to include all offshore trading partners, the CNH deposit pool in Hong Kong doubled to USD 108 billion16; providing the critical mass and foundation to further develop the offshore RMB financing market and the RMB loan market. While the offshore RMB market is expected to continue to flourish, this will depend on the availability of RMB-denominated investment instruments offshore, in particular the offshore-RMB bond market.

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RMB Bonds

The desire to internationalize the RMB and the need for the RMB to settle trades are both key factors behind the rapid growth of the CNH offshore bond market, which is often referred to as the dim sum bond market. The performance of the RMB offshore bond market exhibits strong association with appreciation expectations. Liberalization of trade settlement by the Peoples Bank of China in July 2010 may have triggered strong market sentiment to expect RMB appreciation. It in turn led to a rapid acceleration of deposits in Hong Kong and sparked interest by corporates in accessing this new pool of funds for financing, which was evident in the steady increase in volume of issuance in late 2010 (see graph for Offshore RMB Bond Issuance Volume). Soon by late 2011, as expectations of RMB appreciation tempered (see graph for USD CNH exchange rates), the volume of issuance fell. The market began to rebound in early 2013, which was likely to be supported by the further easing of cross-border capital controls and a continuing increase in CNH deposits fuelled by renewed sentiment on currency appreciation.

The RMB offshore bond market acts more like a vehicle for private investors to take advantage of currency movements than a sustainable long-term investment instrument. However, the major four banks, Chinese policy banks, and large state-owned enterprises have been and will continue to be major issuers. The ability of these large corporates to obtain regulatory approval to issue RMB bonds signals the Chinese governments strong sponsorship of the CNH market and hence, lends further credibility to the RMB bond market. It is particularly true if such credibility remains strengthened which would prevent the market from stagnating or losing its momentum once appreciation expectations are met.

V Onshore/offshore links and policy implications

Though there is scope for a gradual approach to promote development of both Chinas onshore and offshore financial markets, findings from the IMF17 suggest that there seems to be strong and persistent volatility spillovers between the offshore and onshore markets. Given that volatility in the offshore market has been higher than in the onshore market, these findings imply that offshore market developments should be monitored carefully, as they could impact exchange rate stability on the mainland. More importantly, growth of the offshore market should be accompanied by financial deepening onshore to be able to absorb growing cross-border flows that will necessarily accompany further RMB internationalisation. While the process of RMB internationalisation will advance based on market forces, supportive policies could also be contemplated. Expanding the supply of RMB-denominated assets offshore would be necessary to maintain the momentum of RMB internationalisation beyond appreciation expectations. Most importantly, as discussed in section III, to successfully internationalize the currency, financial deepening onshore should keep pace with the growing offshore market to minimize risks to the stability of the financial sector onshore and to keep the momentum for internationalisation.

VI Political prerequisites for Renminbi Internationalisation

The question of how fundamentally Chinas political system has to change to permit successful currency internationalisation is a debatable one. Can the PRC leadership deregulate interest rate, commercialize or even privatize the state-owned commercial bank? Will systematic reduction of the states presence in China inevitably occur?

Political implications thus exist for the potential internationalisation of RMB. Investors, if they are to

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hold a significant portion of their wealth in the form of a countrys currency, demand arbitrary action by the issuer to be minimised. Therefore, law enforcement is important, and checks on the executive created by political competition are one source of such assurance. However, this does not imply that China will have to transform itself into a democratic system with contested elections in order to successfully internationalize the RMB. It will indeed have to significantly strengthen checks and balances on the Standing committee. Meanwhile, Chinas judicial system, which affects the outcomes of economic and financial disputes, should eventually become independent from the political system. A federal system in which provincial governments counterbalance the role of the central government is also desirable.

VII. Implications for the international monetary system & Potential for multiple reserve currency system

Recently, the implications of RMB internationalisation for the international monetary system are commonly framed as whether and when the RMB will displace the US dollar as the leading international reserve currency, even though the US dollar still accounts for more than 60% of total official foreign exchange reserves, in which RMBs share is comparatively trivial18. In 2010, China and Russia decided to renounce the US dollar and resort to using their own currencies for bilateral trade19. Meanwhile, the decision to designate RMB clearing banks in London and Frankfurt is perceived as Chinas step20 to foster the emergence of an international monetary system with several global currencies, not just one.

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Internationalisation of the RMB may provide a new balance between the multipolar global economy and its monetary system, and thus a step towards ending the world economys dependence on the dollar. The dollar and the RMB could potentially both play major global roles at a point in time that the global economy admits the possibility of more than two international reserve currencies. It is particularly true as the increasing returns to scale and network externalities that create a tendency for investors to gravitate toward the US dollar as a common unit of account and means of payment are becoming less influential in a world in which information on exchange rate is accessible and currency conversion costs are relatively low compared to the past.

There are also rising concerns that the RMBs internationalisation may lead to a system of competing international currencies which could be highly unstable. Investors, including central banks, could be prone to shifting the composition of their reserve portfolios as a response, rendering the exchange rates between major currencies more volatile. Historically, there have been examples of both stable and unstable multiple reserve currency systems: a relatively stable configuration before 1913 when sterling, the French franc, and the German mark all played consequential international roles, and an interwar system in which sterling and the dollar competed, but during which the world suffered from severe instability. The stability of such systems, often hinges on the stability of policy in the issuing countries. The potential for entering a competing global currency system thus depends on the reactions from other major currencies regarding the progress of RMB internationalisation.

Conclusion

For Chinas difficult and yet hopeful journey of RMB internationalisation, a remark given by Deng Xiaoping, Chinas revolutionary statesman summarises all: Keep a cool head and maintain a low profile. Never take the lead but aim to do something big.

At a global level, there has been increasing interest in successful RMB internationalisation and particularly, in Chinas emergence as a new source of global liquidity. Successful RMB internationalisation requires long-term structural reform of its central bank, financial institutions and even its political structure, with minimised exposure to instability while it gradually opens its financial market. Though the central bank and the Chinese government continue to operate on a central planning basis, the Chinese economy has already embraced fluctuations through volatility channels between offshore and onshore markets. With strong macroeconomic fundamentals, China still requires further financial deepening within the domestic economy while managing a steady expansion

of RMB-denominated financial instruments at a global level. Chinas long-term objective of advancing the RMB beyond the position of just a transactional currency for trade (or a vehicle for investors to take advantage of currency movements) is yet to achieve.

Helen Liu

y.liu80@lse.ac.uk

Appendix

1) Top 10 in overall index ranking: http://www.weforum.org/reports/financial-development-report-2012

2) RMB deposits/certificate of deposit outstanding amount: Hong Kong Monetary Authority

3) USD CNH Exchange rates: Bloomberg

4) Offshore RMB Bond Issuance Volume: Data originated from Bloomberg, PBOC, compiled by BOCHK

5) Graph for Currency composition of official exchange reserves: http://im.ft-static.com/content/images/175de22c-453d-11e4-9b71-00144feabdc0.img?width=679&height=999&title=&desc=The%20dollar%20and%20the%20renminbi

Acknowledgement

I would like to thank Matthew Pennill for his expert advice and encouragement throughout this project.

Chinese Dream: TheOpportunities and

Challenges of the OneBelt, One Road Strategy

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As one of the biggest economies in the world, the rise of China is not negligible. Recently, China has proposed the construction of one belt, one road which aims to collaborate most Asian countries economically. In this passage, Wenchen Chu analyses the opportunities and challenges of the One Belt, One Road strategy. The report is divided into three parts. The first part mainly introduces the background of the proposition of the One Belt, One Road (OBOR) strategy and analyses the differences between OBOR and the Marshall Plan. The second part introduces the two potential benefits of OBORexporting capacity and exploiting foreign exchange reserves. The third part discusses potential challenges that

China may face when implementing OBOR.

Introduction

China is taking further steps towards its peaceful rise. On October 24th, China announced the establishment of the Asian Infrastructure Investment Bank (AIIB) together with 21 other Asian countries, aiming to lend money to infrastructure construction. After several days, China further declared to raise a 40 billion dollar Silk Road Fund with initial principal of 10 billion dollars, which included 65% of its foreign reserves. All these actions are part of a larger blueprint One Belt, One Road, a strategy designed to facilitate Chinas greater collaboration with neighboring Asian countries. Guided by President Xis talk one year earlier in Chinas neighbour countries, these moves at least prove that the construction of a new silk road is not a mere fantasy.

Marshall Plan Junior?

Press often would like to label One Belt, One Road as a new form of Marshall Plan led by China. However, this is not totally true. On the one hand, both schemes plan to export excessive capital, technology and capacity to foreign countries in need, but there remain several

differences between the two schemes. Firstly, the means of support is different. In the Marshall Plan, the US provided aid money to European countries and most of the money flowed back from the exports of US consumption goods. In OBOR, the benefits are mutual in that it involves an FDI contract helping neighbor countries develop their infrastructure facilities, with China able to earn back from following returns (e.g. fees to use the bridge). It is also estimated that the support of infrastructure is much larger since infrastructure is an upstream industry and it can generate externalities to downstream ones1. Second, the political stand is different. While the Marshall Plan also serves the USs ambition of implementing its strategy of containment, OBOR is purely economical; it focuses on the economic development of Asian countries. Thirdly, the positions of the countries are different. European countries in the Marshall Plan were passive receivers who were desperately in need offoreign reserves and necessities. Asian countries, however, are the equal counterparties of mutually beneficial contracts. In all, OBOR is not another form of Marshall Plan, although it does need to learn from the successful implementation of it. For example, the way to exchange RMB with other currencies of counterparties should be carefully designed so as to guarantee a smooth exchange1.

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A stone that kills two birds

A strategy such as One Belt, One Road can surely trigger many thoughts with potentials. The first one is relevant to Chinas foreign reserves. Chinas foreign reserves have always been large due to its long-term trade surplus (see chart 16). As a matter of fact, it is important to figure out how to make use of these reserves. Foreign Direct Investment (FDI) is one of the options. As mentioned above, the Silk Road Fund will be backed by 6.5 billion dollars of foreign reserves. The fund is designed to help boost the implementation of OBOR by providing funds for construction projects. This will reduce Chinas reliance on its dollar assets that take up nearly 70% of the total reserves. In addition, it may also help China to gain greater pricing power in natural resources and commodities through overseas M&As. Another important reason is to induce the private sector to make investment out of the door. Even though government investments can be large, their effect as a role model to the private sector should be considered a more important function. The huge amount of private sector investment that outnumbered government investment during the Marshall Plan serves as a benchmark. As Professor Zhijie Ding pointed out, it is a good way to transfer the nations wealth to private sectors and loose up the regulations regarding FDI2.

Another important function of OBOR for China is the shift of excessive capacity. In China, this has always been a big problem, especially in cement, steel, aluminum and other building materials industries. The proposition of OBOR is beneficial to China in that there is a larger to demand to fit its supply of infrastructure construction. It is also beneficial to the neighbor countries in that there is an opportunity to import technology from China as well. Moreover, the infrastructure may well serve the need to boost up these nations economic growth rates because of its externality as an upstream industry.

Challenges faced by OBOR

While most opinions are giving out compliments

and high expectations to the OBOR idea, it is worth noting that the challenges are not small. The largest one is the return to investment. China is very famous for its investment driven economy, and this form of development mode has its problems. Domestically speaking, there are a lot of infrastructure constructions taking place in the northwestern area that sadly cannot meet the purpose of boosting local economic development. This leads to a failure to provide returns to initial investment. Similar to this, investments to emerging markets in Asia are high risk. Two specific examples can further illustrate this. The first is Myanmars Myitsone Dam Project, which was built by Burmese government contractors (Asia World) and the China Power Investment Corporation (CPI). On 30 September 2011, amid democratic reforms in the country, President Thein Sein announced that the Myitsone dam project was to be suspended during his tenure. Tens of millions are lost per month solely to pay maintenance fee and leases. The second example is Venezuela. Since 2006, Venezuela has received 50 billion dollars of support from China. In return, it promised to export 330,000 barrels of petrol daily and to pay back all the debt in three years. Although a close ally of China, it failed to follow through on its promise because of domestic turbulence as well as a plummet in global oil prices. The Heritage Foundation has established a database called Chinas Global Reach to track Chinas oversea investment projects (see chart 23). This shows that from 2005 to 2014, there were 130 troubled transactions altogether, with a sum value of 235.9 billion dollars. From all these examples we can conclude that the only guarantee of all investment returns is a good local economic development4.

Future Prospects: A Rose with thorns

There is no doubt that most people think positively about the One Belt, One Road blueprint. The stock market has been proving this: the market is in a strong upward trend that is very rare for recent years. Among the listed stocks, construction-related ones are leading the market (see chart 3, which compares the recent performance of

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several typical listed construction companies with the Shanghai Stock Exchange Composite Index5). The rise is not a speculative one, since most of these companies have already received contracts from the nearby countries. This illustrates the expectation of the market. Despite a lower expectation for GDP growth next year, China is enjoying a higher quality of economic growth. And the quality of economic growth is defined by other economic goals, which include lowering the unemployment rate, stabilizing inflation, developing eco-friendly growth, and balancing unequal regional developments. Looking from this perspective, OBOR does have the potential to transform Chinas economic

growth into one with better quality. Combining with the financial reformation marked by the recent proposition of the Shanghai-Hong Kong Stock Connect, the whole picture of Chinas global strategy is becoming even clearer. But to achieve what it wants, China still needs to handle a series of issues such as geopolitics and risk-return calculations. After all, China is not rich enough to be a philanthropist.

Wenchen Chu

w.chu1@lse.ac.uk

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EMERGINGECONOMIES

Emerging Markets 2025

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Great investment ideas are short in supply as market unsteadiness continues in 2015. While those at the financial steering wheels are not afraid of (and even wish for!) some minor earthquakes, the year ahead seems to be approaching a tectonic plate divergence. On one side, the US Federal Reserve and the Bank of England are planning their first interest rate rises. The other side, featuring the Eurozone and Japan, are engaging in monetary stimulus in order to avoid a recession. The noise regarding the diverging major economies will, most likely, stop many people noticing all sorts of changes in emerging countries. As a result, the authors of this article, Agne Stengeryte and Matthew Pennill, look into emerging market economies in the hopes of discovering above-average long term investment opportunities. A construction of a comprehensive index of future prospects for these economies is followed

by a written analysis of markets that come out as having the most promise.

Beyond the Obvious: a Look into Emerging Economies

With interest rates to be hiked in the US and UK early in 2015, are there any good investment opportunities left in the Emerging World? Within Emerging Markets, is there anything worthwhile beyond the BRICs? In order to answer these questions, we look at 14 developing economies, namely Iran, Colombia, Morocco, Mexico, Poland, Malaysia, Thailand, Chile, Costa Rica, Kazakhstan, India, Nigeria, Kenya and Egypt. These countries investment potential and opportunities are assessed based on a composite

index, which, in our view, is constituted of key drivers of economic prosperity.

We identify several areas of untapped opportunities reflected by political developments, human capital, technology potential, ease of investment and economic stability. Having summed up the index results, the 14 countries in question exhibit clear patterns that could be interesting to investors of varying sentiments. Chile, Poland and Malaysia are grouped as Pack Leaders with Costa Rica and Thailand representing the Surprise Package. Those interested in Latin America should

0 20 40 60 80 100 120 140 160 180

Myanmar

Iran

/Colombia

Morocco

Mexico

Poland

/Malaysia

/Thailand

Chile

Costa Rica

Kazakhstan

Cuba

India

Nigeria

Egypt

Kenya

Emerging Markets 2025 Aggregate Index

Series1

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consider our Latin American Alternatives, comprising Mexico and Colombia, while Kazakhstan, Morocco, Iran and Egypt, falling into Ones to Watch group, should only be considered by risk hungry investors.

Pack Leaders

Chile, Poland and Malaysia, with respective overall index scores of 157.89, 154.70 and 135.14, turn out to be the most promising investment areas. Chile, among the best rated Latin American and emerging economies, is often mentioned when speaking about solid and stable economic growth and social improvements. The country, among the top 11 worldwide in terms of FDI investment (UNCTAD, 2012), boasts with highly educated and expert workforce, a tax-friendly and transparent business environment and a low-risk profile (AA- by Standard & Poors; Aa3 by Moodys; A+ by Fitch Ratings). Indeed, the World Banks ease of doing business ranks Chile 41st, with many European countries, including Luxembourg and China, ranking lower. The Chilean index result is also supported by a high number of internet users (c. 66/100) and exceptionally low public debt as percentage of GDP. In terms of investment opportunities, the most promising sectors are energy and mining. Being a large net importer of oil, Chile is also bound to benefit enormously from plunging crude oil prices. From a 10-year investment perspective, the best way to capitalize on Chilean opportunities while assuring maximum liquidity would be to long iShares MSCI Chile Capped ETF (see chart1).

Poland is the second country in the Pack Leaders division. Having escaped the crisis with relatively few negative consequences, it is another country in possession of almost impeccable economic stability and a stable annual growth of circa 3% driven by domestic demand. Poland is an attractive FDI investment area due to its highly skilled workforce, which partially enters Emerging Markets 2025 index through high scores in tertiary school enrollment and adult literacy subindexes. A slight threat, given 10 year investment framework, would be the countrys membership of the EU and the looming Euro adoption deadline. With the recent European economic turmoil and the ECBs questionable proposals of QE it is unclear whether the country will

adopt the Euro, exit the EU or manage to negotiate the retention of its national currency following the likes of the UK and Denmark. If European stagflation persists, it would hurt the countrys exporters as circa 80% of sales go to the block. Struggles in the German economy, which receives around 25% of Polish exports, is another threat to the economy. Moreover, tensions in the Ukraine and the consequent trade sanctions on Russia are already felt by the economy2. Despite the short-term struggles, the country remains an above-average investment opportunity. Consider going long iShares MSCI Poland Capped ETF in order to capture the trend (see chart3).

Finally, Malaysia, a country which is soon to be on the radars of many emerging markets investors, is another Pack Leaders country scoring a high 135.14 on our Emerging Markets 2025 index. Not counting the Vision 2020 plan Malaysia is already in possession of a strong economic background that will result in growth opportunities in the next 10 years. Malaysia is a country which has only recently emerged from the dependence on agriculture and manufacturing sectors. Nevertheless and somewhat similarly to Chile and Poland, Malaysia boasts export-driven growth and extraordinary technological advancements. Moreover, the government is exceptionally keen to attract FDI by offering attractive tax incentives and implementing schemes such as the Liberal Equity Policy or Employment of Expatriates. From relatively high scores in school enrolment and adult literacy it is safe to state that Malaysia also offers a well-educated workforce. The government has set up the Human Resource Development Fund (HRDF) and the Department of Skills Development (DSD) to ensure constant quality improvement in the Malaysian workforce. It is also important to mention the nations impressive network of highways, seaports, airports and industrial parks whose potential is yet to be capitalized on by businesses. Because of the limited ways to gain access to Malaysias market, it is easiest to buy iShares MSCI Malaysia Index Fund ETF (see chart4).

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The Surprise Package

The Surprise Package, as the title suggests, contains two ASEAN countries which, slightly unexpectedly, score relatively highly in our Emerging Markets 2025 index. In particular, Costa Rica and Thailand surprise with indexes of 119.98 and 114.57, respectively. Costa Rica is no longer about bananas, cattle and coffee; similarly to countries mentioned beforehand, Costa Rica is morphing into a well-trained human capital economy with much potential in the technology sector. Sometimes dubbed as Silicon Valley of Latin America, the country is adding more and more internet users per 100 residents every year and can boast a stable and robust political order. Thailand, another Surprise Package country, is benefitting enormously from its geographical position and close trade relations with China, India and ASEAN economies. Defined by steady growth of GDP and a strong export industry, the economy is full of natural resources and possesses a skilful, yet not costly, labour force. Thailand is also well prepared to tackle infrastructure issues with seven international airports, good internet access and several seaports. The country is also improving its ease of doing business rating. However, there might be a slight twist to the success story: Thailand is a politically divided country still operating under martial law and a 10-year history of turbulence in politics.

Latin American Alternatives

Mexico and Colombia represent two nations which could serve as profitable alternatives to the BRICs for emerging market investors. Respectively, they score 96 and 102 on our index, making their fundamentals very comparable to those of Brazil and China. Both Latin American countries score highly in terms of economic freedom (ease of doing business and trade freedom), and they also rate favourably on core economic variables, such as price stability and public debt. As with all emerging markets, however, Mexico and Colombia are not without their risks. While Mexico is not as free from corruption as one might prefer, Colombia ranks poorly in terms of political stability.

Perhaps of more immediate concern to the investor is the availability of investment opportunities, given that both nations have low market capitalization values in our index. Avianca, the airline holding company, offers one such opportunity for those wishing to gain exposure to Colombia. NYSE-listed, this is the Colombian flag carrier and has been operating for nearly 100 years5. The airlines membership of Star Alliance, the airline group, means it has the potential to benefit from lucrative codeshare deals, and Colombias location as a natural gateway to South America from the

North means broader Latin American growth could fuel this companys profitability. Moreover, Aviancas share price has not benefitted from the fall in global oil prices like the stocks of other airlines (see chart6), suggesting there is room for an upside move in the Colombian carrier (though the falling value of the Colombian peso is partly responsible for this7).

Mexicos inclusion as an emerging market of interest should not come as a shock8. However, it is somewhat surprising that it isnt often placed in the same league as the BRICs. While it scores a little lower on our index than an average of Brazil and China, the countrys membership of NAFTA and its reputation for the labouriousness of its workers9 are just two examples of Mexicos strong economic foundations, which should reap long-term benefits.

Ones to Watch

Our Ones to Watch represent a varied mix of countries from our analysis. Morocco and Kazakhstan especially surprised by their strong performance, and Egypt rated more highly than its seemingly more popular African cousin, Nigeria.

However, Iran is perhaps the most interesting of the four, scoring 88 on our index to put it ahead of countries like India and Nigeria. The Islamic Republic ranks highly for its low public and external debt levels, its high level of interconnectivity, ease of doing business, and educated population. Myanmar and the African economies aside, it does have the worst state stability score in our index and its history of double-digit inflation rates (45% at their highest10) gives it a poor price stability rating. In the past, the countrys political situation has resulted in a significant brain-drain from its borders, which has meant its economy hasnt benefitted fully from its skilled population11. However, just as a reforming moderation in Irans foreign policy might help remedy this historic problem, the impact of falling oil prices on the Iranian economy comes into focus. Iran represents a risky bet indeed, and lots would have to go right for such a bet to pay off.

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The political climate is also an important consideration when assessing Egypts potential. While the country is one of the lowest scorers according to political stability, it scores well for measures of trade freedom, interconnectivity, and FDI net inflows. However, Egypts price instability, debt stocks, low literacy rate, and imperfect corruption score suggest that some of the fundamentals for long-term economic development, and thus investment returns, are not in place, and the countrys political fragility only adds to this. Some more progress on these fundamentals is needed before Egypt can be considered an emerging market worthy of investment.

Morroco rates more highly than our other Ones to Watch in terms of political stability. It benefits from low consumer price inflation, good interconnectivity, and a high ease of doing business score, though its adult literacy rate, R&D spending, and debt stocks scores lag behind. On aggregate, this gives the economy a good score of 95 on our index, ranking it just below Mexico. While agriculture now constitutes only 12% of GDP (see chart), over 40% of the Moroccan labour force is employed in this sector12. The variation of farming yields with weather conditions makes this a potentially volatile industry for such a large proportion of households to receive their income from, acting as a break on the development of domestic consumer spending. Economic diversification should be a primary aim of economy policy in Morocco.

Finally, Kazakhstans final position was unexpected. A look at our index confirms that its rank ahead of Mexico, Colombia and India is not due to outliers or biases in our index methodology; instead, Kazakhstan scores consistently across the index. It is particularly strong on internet and mobile connectivity, ease of doing business, FDI net inflows, and its populations education. Following trend for these Ones to Watch, its political stability score is below par, and the economy also carries the burden of a high external debt stock. As a 1.7 million barrels a day oil producer with the worlds twelfth largest crude oil reserves13, Kazakhstan is also vulnerable to global oil price shocks. A 19%

devaluation of the national currency against the US dollar at the beginning of 2014 will have provided a second hit to the countrys oil export revenues. Close economic ties with sanction-hit Russia14 also mean that Kazakhstan is vulnerable to geopolitical issues beyond its control. Kazakhstans firm foundations for economic development are clear, but its susceptibility to economic volatility outside its control makes it a destination for only the most risk-accepting investors.

Concluding Remarks

With the advanced economies enjoying mixed performance and facing uncertainty ahead, emerging markets should be of keen interest to long-term investors. From Costa Rica to Chile, Malaysia to Mexico, there are a wide variety of opportunities to be taken in countries with strong ecnomic growth potential. As global economic dynamics change, some of the nations in our analysis will make up the hottest growth markets in 2025.

Agne Stengeryte and Matthew Pennill

a.stengeryte@lse.ac.uk m.pennill@lse.ac.uk

Appendix: Notes on Methodology

Goldman Sachs How Solid are the BRICs? paper15, which introduced the term Next Eleven served as the methodological basis for our study, though with significant amendments. As well as altering the variables (see below) and countries (see above) included in the analysis, the construction of the index was amended. Goldmans index was constructed entirely using variables that were also part of the analysis; specifically, each nations index figure was a function of the other economies equivalent figures. This represented a significant limitation of the study, we believe, as each countrys index score was dependent on the relatively arbitrary choice of which economies to include in the analysis. To remedy this situation, we constructed our subindexes using as the base an average of two indexes one based to Chinas figures and the other to those of Brazil. By doing so, we aimed to avoid the issue of index basing on a variable in the analysis, while concurrently ensuring that the choice of baseline figures did not influence the countries relative outcomes. As two of the worlds newest economic powers, we considered Brazil and China to be good bases on which to construct our index and to assess the economic development potential of the countries in our analysis. For comparative purposes, economies that score more than 100 on our index rank ahead of a

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simple average of China and Brazil on our assessment of economic potential.

The variables we chose to incorporate into the analysis are designed to serve specific functions. Most importantly, rather than indicating current growth conditions and short-term, cyclical macroeconomic prospects, the variables, and thus the index as a whole, offer a broad signal of countries future, long-term prospects for economic prosperity.

We also excluded some variables that were in the N-11 report from our analysis to provide a more up-to-date framework for assessing growth prospects. Specifically, we excluded Penetration of PCs (the growth of mobile technology has made personal computers a less essential stimulant of growth, we believe), Penetration of Phones (this measured landline connections, so again mobile technology has made this less relevant), Investment Rates, and Openness of the Economy, and we used suitable proxies for the latter two measurements.

In addition to (or in two cases as replacements for) these excluded variables, we included some new measurements for reasons outlined below:

Mobile cellular connections per 100 people This replaces the measure of landline connections Goldman included in its original report. The penetration of mobile phones is important for a variety of reasons, from developing essential communication links for businesses to facilitating mobile banking for individuals and entrepreneurs.

Ease of doing business index This can be an important determinant of firms willingness to invest and the speed with which enterprise can expand.

FDI Net Inflows As a proxy for the investment rates used in Goldmans report, this also serves as an indicator of foreigners propensity to invest in the economy.

Tertiary Education Enrollment An important measure of human capital, high levels of which can propel development.

Adult literacy rate An indicator of basic educational standards.

Market capitalization of listed companies This serves as an indication of the nations financial development. A developed financial system is essential for allocating capital resources efficiently and for the provision of credit to corporations wishing to invest.

R&D Expenditure A measure of the countrys input into technology development, which is a long-term driver of economic growth.

Trade Freedom As an alternative measure of the

openness of the economy.

Birth Rate In line with the Demographic Transition Model, birth rates tend to fall as countries progress along their development path.

Gross Fixed Capital Formation Another proxy for Goldmans measure of Investment Rates.

Furthermore, it is worth noting that in cases where the original data from the N-11 report is now unavailable, we chose to use suitable close substitutes. In the case of countries where specific data points were unavailable, we excluded these variables from that countrys index total. Where necessary, we reverted measures so that higher scores always correspond with better outcomes on the measured variable.

The final index used was constructed of the following variables.

Consumer Price Inflation (10-year average)

Public Debt (as % of GDP)

External Debt Stocks (as % of GNI, 10-year average)

Internet Users per 100 people

Average Years of Secondary Education

Life Expectancy at Birth

State/Political Fragility

Trade Freedom

Rule of Law

Mobile Cellular Subscriptions per 100 people

Birth Rate

Ease of Doing Business

FDI Net Inflows (as % of GDP, 10-year average)

Gross Fixed Capital Formation (as % of GDP, 10-year average)

Tertiary School Enrollment

Adult Literacy Rate

Market Capitalization of Listed Companies (as % of GDP, 10-year average)

Research and Development Expenditure (as % of GDP)

Freedom from Corruption

*We used ten-year averages where appropriate as a simple means of filtering cyclicalities from the data.

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ADVANCEDECONOMIES

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Abenomics 2.0:Will Japan Make or Break?

Following Shinzo Abes re-election as Japanese Prime Minister in December, Casey Chan analyses the future of Abenomics. Specifically, he addresses the extent to which the first two arrows of Abenomics have been successful thus far, before turning to structural issues. These, he argues, are crucial to Japans long-term prosperity, yet many of the structural reforms Abenomics promised to deliver have yet to come to fruition. His conclusion is that

2015 will be a defining year for Japan and its Prime Ministers economic legacy.

Introduction

Just several weeks after Shinz Abe was re-elected as Prime Minister of Japan, the Liberal Democratic Party (LDP) announced its unconventional plan to rescue Japan from its two decades of economic malaise, termed Abenomics. The three-pronged approach to Japans Lost Decades was quick to spark interest amongst Nobel laureates, central bank governors and economists worldwide.

The enormous monetary experiment and sizeable

fiscal stimulus packages have effected short-term improvements and have produced signs of vitality in the Japanese economy; however, for how much longer can Abe avoid dealing with Japans structural issues? With the media hype surrounding the first two arrows, it is easy to forget about the more important third arrow and its considerable lack of momentum. This article will focus on the long-term issues of Japans institutionalised sexism, demographic crisis and retrograde immigration policy, and how Abe plans on solving them.

Abenomics sceptics are aplenty and Japans aversion

rhetoric thus far. With the LDPs extended mandate, Abe has the rare opportunity to effect long-term structural reform such as negotiating the Trans-Pacific Partnership and increasing female participation rates in the labour market.

Double down wager

BoJ Governor Kurodas firing of the first arrow has had relative success in boosting long-term inflation expectations, with nearly 70% of all Japanese government bonds (JGBs) issued being bought by the central bank9. With the yen depreciating against 27 of the 31 most-traded currencies since mid-201410, firms regained their competitive edge and corporate profits soared. However, the inconceivable scale of the quantitative easing programme is not without its risks.

One of the main uncertainties of the monetary stimulus is the consequence of the plan succeeding and how the BoJ is going to execute its QE exit strategy. Consider the scenario where investors and the public hold an optimistic view on the Japanese economy recovering and inflation hitting the 2% target. This is likely to result in an increase in JGB yields and the BoJ intervening with

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to reform is still holding the country back. However, if anyone is confident, it is Abe himself, declaring, Japan is back. Keep counting on my country. 1

Abes Blueprint

With Mr. Abe and the LDP confidently winning the recent snap-election, Abenomics is here to stay until 2018, but what exactly is behind this term and the resulting new mandate? Abenomics is a Keynesian-inspired plan based on three arrows monetary policy, fiscal stimulus and structural reform all of which have had questionable levels of success. As stated by Abe, the immediate goal of Abenomics is to put an end to deflation, first and foremost 2 and in the long-term to maintain robust fiscal discipline as we set the economy firmly on track to sustained growth 3.

The first and, undoubtedly, most audacious arrow of monetary policy, comprising the Bank of Japans (BoJ) unprecedented stimulus, shocked global markets. Its objective is primarily to eradicate Japans deflationary mind-set and to increase private investment and real wage growth. Just as the Federal Reserve confirmed the end of its quantitative easing programme, the BoJs Governor Kuroda announced an enormous increase in Japans already substantial monetary stimulus programme, far larger than anything attempted by other central banks in history, alongside an increase in the average duration of its bond purchases from 7 to 10 years. The higher target for the annual increase in the monetary base, from 60-70 trillion to 80 trillion4, will see the BoJs balance sheet increase by 15% GDP per annum (see chart5).

The second arrow of fiscal stimulus has caused noticeable turbulence in the Japanese economy, in particular, the effect of the premature increase in sales tax, which Abe soon regretted. At the onset of Abenomics, a 10.3 trillion stimulus package was ordered to encourage private investment and to improve infrastructure. However, in April 2014, Abe announced a shift in fiscal policy from expansionary to restrictive, increasing the consumption tax from6 5% to 8%, landing Japan in two consecutive quarters of GDP contraction. The current targets are to increase the consumption tax to 10% by April 2017, to decrease corporation tax from 35% to below 30% over several years, starting in April 2015, and to half the primary balance deficit by fiscal year 2015 and to achieve a surplus by 20207.

The final and most keenly awaited arrow constitutes structural reform, aiming to tackle Japans entrenched structural issues and to improve long-term prospects. As the most important arrow in my [Abes] armoury8, said by the Prime Minister, it included proposed changes to the labour market, deregulation and reforming key sectors most of which have proved to be empty

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further liquidity injections to keep yields low. With rising debt-servicing costs, the government will also have to find ways to increase tax revenues whilst maintaining its goal of fiscal discipline, if possible. Japans historical dependence on monetary policy also raises doubts as to whether Kuroda will be able to devise a clean exit strategy.

Another significant risk is the possibility of the yen depreciation sparking currency wars with regional neighbours, specifically China and South Korea. In China, where manufactured exports are experiencing a challenging slowdown and the overvalued Renminbi is putting pressure on export competitiveness, stimulus through depreciation seems tempting for policy makers. Kuroda should avoid the possibility for a round of disruptive devaluations with Japans main trading partners at all costs.

Japans national debt exceeded the one quadrillion yen mark last year, representing an eye-watering debt-to-GDP ratio of 240%11. Japans ageing and declining population, a trend which has been progressing at a much faster rate than economic growth, has largely contributed to the dire financial situation. Japanese public finance faces a number of challenges, including fiscal and social security reform, many of which depend on structural reform to be executed by the third arrow.

Social security is Japans largest area of public expenditure and it is consistently increasing at an annual average of 2.6 trillion12. Alongside Kurodas second shot of monetary stimulus, it was announced that the $1.2 trillion Government Pension Investment Fund (GPIF) would cut its allocation to domestic bonds to 35 per cent from 60 per cent, while upping its share of domestic stocks from 12 per cent to 25 per cent 13.

Whilst capitalising on the effects of the first arrow, the new asset mix also aims to assist meeting the rising pension payouts. The shift to greater stock market exposure has its risk of volatility in the short-term and the GPIF wagers its confidence in Abenomics spurring a long-term recovery to increase yields for its 31 million pensioners and counting.

Without considerable reform, Japans fiscal position will become increasingly unsustainable. With very little planned to significantly increase tax revenues and tackle debt, Japan is likely to experience significant public service cutbacks and declines in living standards.

The final arrow of structural reform is essential in propelling the short-term growth stimulated by the first two arrows into sustainable growth. With Japans long-term structural issues already deteriorating its stretched fiscal position, reforms are needed immediately so that the momentum from the stimulative policies is carried forward for future generations. The issue of the nations participation gap and its shrinking population, which are explored below, are just two of many structural problems in Japan, but taking a long-term perspective, they are two of the more noteworthy.

The Female Problem

Out of the developed economies, Japan has one of the lowest gender equality rates, ranking 104th out of 136 countries14, just marginally higher than Nigeria and the UAE. With just 1 in 10 senior management positions filled by women and a 63% female labour force participation rate14, the lack of women in the workforce is one of the biggest structural issues that Abe faces,

hindering Japans recovery.

Sexism in the workplace is rooted in Japanese culture and tradition, where women earn on average 30% less than men and 70% of working women quit after having their first child15. Balancing both full-time work and child rearing in Japan is very demanding, if not borderline impossible, due to the working culture. The two main reasons cited by Japanese mothers for why they left their job after giving birth were Working hours making child care infeasible and Workplace lacking in willingness to support mothers 16. Where devotion and loyalty to a corporation is a significant factor in career progression, known as the seniority system, a large majority of firms do not invest in skills training for women and marginalise them, resulting in many women being discouraged from working. For the remaining women in the labour market, few are able to climb to the top of the corporate ladder due to the glass ceiling that is institutionalised sexism.

Abe is keen to solve this entrenched structural issue, which has been coined Womenomics, and has set out a plan to empower women in Japan. The lacklustre economy and tax base have much to gain by increasing female employment, with figures provided by Goldman Sachs stating by closing the gender employment gap, the potential boost to Japans GDP could be nearly 13% 17. The economic case is strongly in favour of

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Womenomics, especially with its colossal public debt burden on the increase.

So far, Abe has managed to increase day-care capacity by 130,000 12 and reduce the number of waitlisted children; however, nothing has been done to improve female representation and to promote flexible work environments. With Japans gender equality ranking rising by only one place since the start of 2013, there has not been any significant progress. Furthermore, numerous sexist comments by members of the LDP casts further doubt on the ability of the politicians behind Womenomics to tackle this issue.

The Vanishing Nation

By 2050, Japans working age population is set to have shrunk by 37%, facing the steepest decline amongst the MEDCs and worldwide18. In addition, Japan faces a massive demographic crisis the elderly currently make up a quarter of the population and this is set to increase to 40% by 206019. When tackling the ageing and declining population, Abe faces a series of intertwined issues institutionalised sexism, birth rates, social security expenditures and immigration policies all with a gigantic debt burden. With many major economies projected to experience similar trends, Abe

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leads in driving the urgently needed structural reform to confront the demographic time bomb and the looming labour shortage.

Similar to Germany and Italy, Japan faces this crisis as a result of fertility and mortality evolution alongside several unique socioeconomic factors. In the late-1940s, Japan experienced a post-war baby boom and from the 1950s onwards, fertility and mortality rates declined relentlessly and life expectancy surged to one of the highest levels in the world. With a minute 1.63% of the population currently represented by foreign residents and nearly zero net immigration, Japan has little to compensate for its particularly low birth rate19.

The future implications of Japans shrinking labour force will make the goal of sustainable growth and its 2% inflation target more problematic than once thought. With an increasing proportion of elderly people, social security spending will continue to climb and remain a substantial tax burden on the government. Around one-third of the colossal $937-billion government budget for FY 201420 was entirely accounted for by social security expenditures, pressurising Abe into a premature sales tax increase. Furthermore, Japans resultant diminishing tax base puts added pressure on the governments fiscal dilemma.

To Bloomberg View editor, Pesek, the root of Japans supposed sex drought isnt culture, but economics21.

With one of the lowest fertility rates in the world, many are quick to argue that Japanese people have little libido. However, the booming semi-legal sex industry, which is estimated to generate $24 billion a year22, says otherwise and may point to economic factors. Considering that most mothers struggle to find a balance between full-time work and rearing children, in most cases, males have to feel financially secure enough to be the main breadwinner to support their wife and potential children. Under declining real wages, growing living costs and long working hours, the idea of raising a family is a daunting prospect. With a record low number of actual births in 2013, what is Abes plan to increase the fertility rate?

Through Womenomics, Abe aims to promote more flexible work environments so that women no longer have to choose between full-time work and child rearing, although no policies have been drawn up as of yet. The progress made in expanding day-care capacity and reducing the number of waitlisted children has helped nudge Japans birth rate to 1.42, a 16-year high23. However, it is still far below the rate of 2.1 needed to put a halt to Japans long-run population decline24. Many critics believe that Womenomics on its own will not be able to tackle the demographic crisis and that Japan will have to face the necessity of immigration.

Immigration is one of the most politically sensitive topics in Japan and politicians rarely bring it up independently.

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The insular mind-set is widely held across Japan, which was institutionalised through the governments no immigration principle in 1998 and a virtually identical Nationality Law of 1899 25. Both stated the need to prohibit unskilled labour migration and that foreigners remain entrants not immigrants 25

Shinz Abes view is no different, evident as he boldly rejected the prospect of lax immigration controls live on television. In 2012, Abe introduced a points-based immigration system to give preferential treatment to foreign professionals applying for visas. After a year of operation, the programme received 434 registrants and attracted only 17 foreigners due to excessively tight criteria, which have recently been relaxed27. Nonetheless, recent changes giving longer visa stay periods to foreigners working in construction will help fill the sectors labour shortage; similar extensions for doctors, nurses and service workers would also help alleviate shortages.

Defusing the demographic time-bomb will require strong political will from Abe. With Japans enormous debt burden, an ingrained cultural aversion to immigration, record low birth figures and flatlined productivity growth, Abe has to act now before it is too late.

Last Throw of the Dice?

Shinz Abe has undoubtedly revitalised Japan and has put the country back under the spotlight. Whether his campaign for revival will succeed is still in question, largely due to the disparity between Abes glossy rhetoric and reality. With his extended mandate, Abe has the rare opportunity to push forward with his economic policies and, more importantly, structural reform. The third arrow is imperative for Japan in the long-term but as of yet, Abes push for impactful reforms has been relatively glacial. Adding the enormous monetary stimulus and fiscal packages, Abenomics bears an unfortunate resemblance to a scaled-up version of the economic policies deployed during the Lost Two Decades. However, Abe still has support from the public and is one of the few rays of hope that might rejuvenate Japan into the powerful economy it once was. 2015 will be a defining year for the Prime Minister will Japan make or break?

Casey Chan

c.a.chan@lse.ac.uk

European Outlook:2015 and Beyond

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As the Eurozone continues to stand on the brink of deflation, Navreen Sandhu looks at the key economic issues facing the currency area at present. While the European Central Bank and its leader Mario Draghi are crucial to the Eurozones survival, she argues, structural reform in the areas three largest economies is also a prerequisite for lasting economic recovery. Though she finds some reasons to be optimistic about the outlook for 2015, her contention is that continuing political turmoil and a lack of conviction among European

leaders will still hold the Eurozone back in the year ahead.

European Outlook: 2015 and Beyond

The Eurozone over the last six years has been characterised by its ability to jump from crisis to crisis without collapse. Many will be hoping 2015 sees the calming of the stormy European seas; however, it seems the opposite is likely to occur. From the tension in Ukraine to rampant unemployment figures, the last year has not seen much in the way of positive news, and the forthcoming elections in Greece, combined with the continued threat of deflation, mean this year could get off to a rocky start. There are at least five defining factors that will shape the European outlook not only for the year ahead, but also for many years to come. Looking at each in depth will enable a better understanding of what can be expected from the Eurozone in the future.

Political turmoil

Although 2015 will be the year of the sheep in China, it doesnt look like European voters will be following the status quo. With potentially defining elections in Britain, Spain, Poland, Denmark, Finland, Portugal and Estonia1, the very future of the Euro is being placed under scrutiny.

The failure to elect a president in Greece has once again placed it at the centre of the current economic

trouble. On this occasion, it is not the threat of default, but the threat of revolt that could throw the Eurozone into turmoil. With its promise to reject austerity and to restructure national debt, the radical left-wing Syriza party looks set to form the next Greek government at the forthcoming election according to recent polls. This could leave the Eurozone facing a crisis on a similar scale to that of 2012, when it appeared it had only days to live.2 The parallels to the Eurozone of three years ago can be seen further in the fear surrounding a Grexit, which is once again being debated.

The rise of these radical parties can be seen right across Europe. In Spain, rampant unemployment and even more severe youth unemployment has contributed to the explosive rise of Podemos. Although only established a year ago, the party is already leading the polls, a clear marker of the level of discontent felt in Europe. Similarly, the National Front in France and UKIP here in Britain are riding on the wave of anti-immigration and anti-EU sentiment felt around Europe.

Discontent is on the rise, with many people disengaged and dissatisfied with politics around Europe. Therefore, in the year ahead, politics will take centre stage alongside the economics in determining the future of the Eurozone.

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ECB

2015 should be the year that Super Mario manoeuvres the Eurozone far away from the deflationary cloud that has been hanging over Europe. One of the major reasons for the political discontent in the Eurozone is that many countries are stuck in the economic doldrums of austerity. Alongside this is the threat of deflation, with the inflation rate registering only 0.3% in November3 (see chart4). The pressure on Mario Draghi to commence sovereign bond quantitative easing rose towards the end of 2014, and unless he acts soon, the Eurozone could be sleepwalking into further trouble. Although there are questions surrounding the effectiveness of QE, the recent slump in oil prices and poor performance of business surveys suggest that inflation fell even further in December. Mr Draghi should act at the earliest available opportunity (the January 22nd ECB meeting) to commence QE, thereby setting the Eurozone off on the right path early in the year.

Nevertheless, not only does the ECB have to act quickly, but it has to act with conviction. A QE programme of insufficient levels will wreak havoc in the markets and do little to ease the deflationary pressure. Despite the resistance of the Germans, the ECB must take a strong stance and use the success of Draghis 2012 pledge to do whatever it takes to save the Euro.

Structural Reform

The three largest Eurozone countries did not have an easy ride in 2014. Germany, despite its healthy balance sheet, posted poor economic results, without falling second quarter output. The French economy is facing the worst of stagnation after three years of near zero

growth; the first time in the post-war period. Italy is still in recession, and GDP is sitting at levels barely above those of 1999 when the euro was launched.

The problems these three face are contrasting, and which without a solution have the ability to derail the Eurozone. Both France and Italy need decisive leadership to push through structural reform, without which stagnation will continue. Germany on the other hand, despite a weakening export market, has the capacity to increase spending, and drive the Eurozone out of trouble. However, it is unlikely that 2015 will see the changes needed in these economies, again due to political reasons.

This month will see the new French economic bill go to parliament. Its primary aim is to deregulate and stimulate the economy, whilst satisfying the European Commission that is it taking definitive steps towards dealing with its budget deficit. However, it seems unlikely that the current proposed measures will be enough to satisfy German critics, including Chancellor Angela Merkel, who believes that what is currently on the table is not yet enough. Germany has already criticised Brussels for allowing the French to breach budget-deficit rules without appropriate punishment, and without radical reform, it appears that they do not trust the French to bring their budget in to line.

Without this trust, the German spending that is required to fire up the Eurozone will not occur. These three large economies have the ability to transform the Eurozone in 2015, but they also have the power to bring it to its knees. The lack of growth, reform and political clout means the strong performance of some countries will not be enough to hide the weakness in the big three.

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External Factors & Silver Linings

One of the largest headwinds for the Eurozone last year was the crisis in Ukraine and tensions with Moscow. Whether this continues into 2015 will be a large factor in determining the direction of growth. The realisation that the Eurozone was not picking up as expected last year came in the spring (see chart5), when it was clear firms were scaling back investment plans. Although this could be attributed to a Q1 2014 slow-down in the US and China, it is largely attributable to the crisis in Ukraine that occurred during the same period. The shock of the Ukraine crisis has been largely underestimated, and although it does not directly impact Eurozone growth, the indirect impacts are large. Combined with the current inventory turnover, it is clear to see why performance was so poor last year.

However, it appears there are some positives underneath all the negative data. The recent depreciation of the euro will not harm exporters, and real M1 growth is suggestive of some form of recovery in the year ahead. Combine this with low oil prices and real wage growth, and the underlying picture does not appear so unhealthy.

Rocky Road Ahead

Going into 2014, confidence of a euro recovery was high. However, as the year progressed, it became clear the Eurozone was not joining the recovery party, with investors once again swiftly withdrawing funds from Europe. The outlook for 2015 should be more cautiously optimistic than 2014. There is scope for a European recovery; however, it is likely that a lack of decisive actions and weak leadership will hold the Eurozone back for at least another year. Although the likelihood of failure has fallen, it appears 2015 will hold many hurdles to clear before the revival can commence.

Navreen Sandhu

n.k.sandhu@lse.ac.uk

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MARKET ANALYSIS

Leveraged Finance in2015: Higher Risk Returns

to High Yield Debt

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In this report, Alex Scott considers how global leveraged finance will develop in 2015. The performance of US and EU leveraged debt markets over the past year was considered in combination with 2014s macroeconomic developments. It was determined that, in line with state of their economies, European and US leveraged Debt markets took divergent paths last year and will continue to do so in 2015. Commodity prices, central bank policy and global growth will be the key determinants of both regions prospects; however, while the US will hope to see increased deal activity and improving corporate profits, Europe will continue to rely on refinancing and expectations of loosening monetary policy. Overall, 2015 should be a year of middling performance and increased risk for leveraged loans and

high yield bonds.

In line with the state of their economies, the leveraged debt markets of the US and Europe took divergent paths in 2014. In the US, loan and bond issuance again became deal driven, as opposed to Europe where the markets are still dominated by opportunistic refinancing. CLO issuance is growing on both sides

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of the Atlantic, as are the number of less stringent covenant-lite loans. Monetary policy, commodity prices, and political stability will be the key determinants how these markets evolve over 2015, which is likely to be a year of moderate performance and increased risk.

US Leveraged Finance: Back to Fundamentals

2014 Leveraged loan issuance in the US was below last years unprecedented level, with full year issuance of $529.5 billion down from the $620 recorded in 20151. Though the year began strongly, a volatility driven scare in August led to a sharp drop in lending, which has henceforth remained subdued2. Concerns regarding market volatility, the international economic climate and rising interest spreads all contributed to investors flight from leveraged loan funds, with net outflows occurring in 31 of the past 33 weeks since the beginning of May3. As a result of this clearing yields have risen, ending most opportunistic refinancing and refocusing the market on deal-driven lending. Indeed the third quarter of 2014 saw M&A related loans make up more than half of the total loan volume for the first time since 20114.

The most significant trend still emerging is the relaxation of loan covenants and a rise in CLO issuance. Having managed to regain the trust of investors since 2008, CLOs are again a booming asset class, readily purchased by yield-hungry investors who are hamstrung by triple-A only investment mandates. CLO issuance for the full year is on pace to reach $124 billion, well ahead of

2006s $96 billion record5. Similarly covenant-lite loans, which remove most protective clauses that benefit the lending party, are also being issued at record levels. The Federal Reserve is understandably concerned with these developments, and found there to be a criticized rate of 33.2 percent for cov-lite lending in its November review of syndicated loans6. Because of this banks are already shedding everything non-investment grade from their balance sheets, wary of newly issued capital requirements. Unfortunately this regulation is a double-edged sword, as the lack of bank capital has gutted market liquidity and greatly increased the risk of volatility sell-offs.

High yield US bonds performed similarly strongly in 2014, with new-issue volume set to come in slightly above 2013s level of $321 billion7. The year began with interest spreads at historic lows, however they have since then widened due to rising investor uncertainty and the aforementioned withdrawal of bank capital. The consensus forecast among investment banks is that next years issuance will be at a similar level of around $260 320 billion; however, this will be subject to several potential disruptions8. The tanking oil price is of particular concern, as most US energy companies are highly leveraged and unprofitable at current prices. Indeed UBS has forecast that high-yield bond default rates could eventually rise above 5.5 per cent, from around 2 per cent currently, if WTI crude oil remains below $60USD a barrel over the next 12 months9. In the medium term a Fed decision to raise interest rates will of course also be significant, which is likely to come in the second or third quarter given the strength of current

36 Perspectives

growth and employment data.

2015 should therefore be a year of steady issuance and middling performance in the leveraged debt markets of the US. The current sell off of leveraged instruments, driven by the plunging oil price, has thus far been contained to those issued by energy companies. Oil prices may well rebound, and regardless the lower energy costs should spur consumption and help non-energy corporations. Sustained growth in M&A activity will keep issuance figures largely unchanged, though there are three headwinds that could trigger broader sell-offs. The first, that the FOMC raises rates sooner than expected, is of lesser concern considering how well this years tapering was absorbed. Should commodities experience an extended rout then they may also spark a rising default rate, however most energy companies are smartly hedged such that little of their debt comes to maturity in 2015. Of more widespread concern is the effect of recent government regulation put in place by the OCC and the Federal Reserve. If accepted levels of leverage are affected then this could stymie deal activity, which is the backbone of all US leveraged finance.

EU Leveraged Finance: Still Driven by Draghi

Europes leveraged loan market continued to grow in 2014. 2013s 65.1 billion issuance total was outstripped by October, with falling prices tempting an increasing number of firms to refinance their transactions10. Volumes are still well below the 160 billion plus recorded in 2007, and M&A related financing remaining

37 Perspectives

subdued11. This lack of deal-derived financing is likely due to an increase in cross boarder loans, with European borrowers who have USD revenue streams being tempted by an American market that allows for higher leverage and fewer loan covenants.

Much like in the US, record volumes of CLOs are being issued in Europe, albeit from a much smaller base. BNP Paribas expects 15 billion to be issued in the coming year, another jump ahead of 2014s expected 11 billion level12. Larger deals are also seeing their covenants relaxed, in order to compete with alternative US financing13. These trends form part of a broader liberalization of the European loan market; where syndication has returned, amortization requirements are falling and covenant requirements loosening.

High Yield bond sales are also booming, with 2014s issuance easily passing the 70.1 billion recorded in 201314. Yields compressed significantly in the first two quarters, with spreads touching 3%, thanks to ECB covered bond purchases and an expectation of further quantitative easing15. Since then lackluster growth, the possibility of deflation and Russias crisis have encouraged a partial sell-off, sending yields back to just below 2013 levels. The collapse of UK phone retailer Phones4U gave investors a stark reminder that high yield still entails credit risk, with the default continuing to haunt current issuances.

In 2015 European leveraged markets will continue to be guided largely by expectations of changing monetary policy. Should the ECB finally vote in favour of wide scale quantitative easing, as is expected, then there is room for additional spread tightening. Short of widespread company defaults, investors will remain willing to add leverage debt to their balance sheets, as they remain hungry for yield and profit. Unfortunately a sell off and rise in defaults is looking increasingly likely, given that growth in the continent remains persistently low, while almost a quarter of all firms in the EU periphery now have net debt at four times their earnings.

For the Investor

Leveraged debt markets are well past their 09-13 growth phase, and as such fund returns in 2015 should be expected to be closer to 5% rather than the 10%+ of years past.

The fundamental outlook for the US markets is positive, with strong growth and employment figures meaning most companies should expect an improvement in profits by the years end. Considering this Decembers sell-off of energy related debt, sparked by the falling oil price, is unlikely to trigger a broader fire sale. Indeed this dip in value has led to improved investment opportunities now that loans and bonds are more realistically priced.

Europe, meanwhile, will remain stuck in an environment where bad news is good news, insofar as prices will continue to be driven by QE expectations. ECB purchases may well contribute to a further rally in leveraged debt markets, however this could also be counteracted by the raise in US interest rates that is almost certain to come in the middle of next year. More syndication and an increased appetite for leverage will also be a feature of the year ahead, with European fund managers still confident in the potential returns of leveraged debt markets.

A strong investment strategy for the beginning of 2015 would be to make the most of Decembers sell-off, and value buy credit from US companies that are distanced from oil and energy markets. Beyond this timeframe concrete advise is hard to provide, other than that it will be crucial to keep a close eye on commodity prices, central bank commentary and Europes geopolitical developments. As we are now approaching the end of a credit cycle, risks will be rampant in 2015, and investors in leveraged