SMU Political-Economic Exchange

AN SMU ECONOMICS INTELLIGENCE CLUB PRODUCTION - South Korea More than just a horse dance? - Is the US Natural gas glut set to continue? - Chinas much needed economic reform
The Fortnight In Brief (24th December to 6th January)

ISSUE 30 7 JANUARY 2013

US: Partial Resolution of the Fiscal Cliff On New Years Day, the Senate passed the American Taxpayer Relief Act of 2013, partially avoiding the Fiscal Cliff. While many issues have been left unaddressed, the bill will extend the Bush-era tax cuts for most Americans and save millions from the Alternative Minimum Tax. World markets reacted favourably to the partial deal, but the debt ceiling in US has once again been hit and the bill does not address this. Despite the uncertainty, employers added 155,000 jobs in December, holding the jobless rate at 7.8%, almost at the lowest level in four years. Asia Pacific ex-Japan: Robust despite Global Economic Uncertainty The regional benchmark index in Asia posted its seventh consecutive weekly advance with US budget deal. Surveys of purchasing managers in Asia point toward an accelerating manufacturing sector. HSBCs Purchasing Managers Index (PMI) for South Korea, Taiwan and India rose from 48.2, 47.4 and 53.7 in November to 50.1, 50.6 and 54.7 respectively. The data indicates that manufacturing in Asia remain robust despite global economic uncertainty. EU: The Pain of Reform In Europe, Markits PMI for the Eurozone was 47.2, a nine month high and an improvement from 46.5 in November, despite the figure being indicative of a contraction. While Europe continues to fix its debt problems, German Chancellor Angela Merkel cautions that although reforms are starting to kick in, economic conditions are likely to be more difficult in 2013. Her words are reflected in the unemployment rate of almost 12% across Eurozone, with budget cuts and tax increases keeping spending and confidence low.

IN COLLABORATION WITH

PROUDLY SUPPORTED BY

South Korea: More than just a Horse Dance

By Adam Tan, Singapore Management University
Psys recent Korean pop sensation Gangnam Style, which has exceeded more than one billion views on YouTube on the very day that the Mayans predicted as the end of the world, is yet another feat that South Koreans can be proud of. This is a sign of how much South Korea's influence in the world has grown since its recovery from the Asian Financial Crisis in 1997-98. The Asian Financial Crisis, which had seen millions of citizens donating their personal gold dowry to the national treasury to allow the government to negotiate a USD 58.4 billion bailout from IMF1, remains a painful chapter in the minds of South Koreans. Since then, the South Koreans have not looked back as their chaebols (South Korean business conglomerates) have gone from strength to strength to emerge as the global leaders in mainstream electronics and lifestyle innovation. Through only Samsung, LG and Hyundai groups, these chaebols have businesses spanning multiple industries such as electronics, insurance, construction, automotive and even shipbuilding. You must be wondering how this has been possible in the span of less than 15 years. This is the South Korean miracle we will be exploring. Leader in Innovation Export There was a time where the words "innovation" and high quality seemed synonymous with the land of the rising sun, Japan; and everyone wanted to own a Japanese TV. Times have since changed as that era has moved past us. As markets consolidate and weaker players get weeded out, Japans East Asian neighbor has done more than just catching up and replicating Japans inventions. South Koreans went one step further to improve their inventions. This neighbor has been one of the contributing reasons to why Japanese consumer electronics were underperforming since the turn of last decade and that trend is expected to continue. Combining sleek and ergonomic designs with cutting-edge technology, Samsung & LG have taken main stage in the recent years. This surge in technological innovation for smart household appliances and mobile devices coincides with the rising purchasing power of the middle class in Asia which has spurred demand for quality South Korean exports globally. China, for instance, is one of the largest importers from South Korea and the trend is expected to continue (see Figure 1). Figure 1: Koreas Exports (Asia/China)

2 Copyright 2012 SMU Economics Intelligence Club

With major economies in the world such as the United States and Europe slowly recovering from the Great Financial Crisis, I expect pent-up consumer demand from these regions to contribute to South Koreas increasingly positive trade balance2. This will be the pillar of growth for the current decade for South Korea. Investments in Growth Markets Besides being good at innovating and developing cutting-edge technology, the ability to create demand is one important lesson to learn from South Koreans. With the financial clout gathered through exporting products around the world, South Korea started investing in frontier economies3 earlier than many other developed economies. Vietnam, one of the fastest growing frontier economies in Asia, puts the case in point. The relationship between these former battlefield enemies has improved as South Korea has played a key role in Vietnams economic progress. This allowed South Korea companies to outsource several functions for lower cost of production and in turn, create demand for their own products in Vietnam as the middle class move up the wealth ladder. This is just one of many examples with other countries in ASEAN such as Myanmar and Indonesia also benefitting from joint ventures in energy, electricity and construction projects. With an increasing focus on Asia as a new engine to drive growth, building long term sustainable relationships early with neighbors is essential and in this case, the South Koreans have done the right thing. Possible Headwind in 2013 There are two sides of a coin to the South Korean miracle. Rising tension since the recent ballistic missile test by their infamous neighbour, North Korea, has always been a thorn in their side. Doubts were raised by political analysts after North Korean leader Kim Jong-Un seemed to signal the will to reduce tension between the North and the South in his recent New Year public speech. However, it is believed to be linked to a further call for aid. Personally, I believe it takes more than just the will but also a significantly long period of time to dissolve the longstanding animosity. Newly-elected President Park Geun-Hye has big shoes left by her father, former President Park Chung-Hee, to fill as the world keep their eyes on how she will attempt to engage their counterpart, Kim Jong Un. This can possibly derail the recent surge in investors confidence in South Korean companies as political risk remains something hard to diversify. However, apart for this long term political issue, South Korea remains as one of Asias hopes of driving global growth and is certainly more than just a famous horse dance.
1 International organisation which aims to promote global monetary and exchange rate

stability to facilitate growth of international trade. 2 Trade account used to track foreign trade value inflows and outflows in a nations accounting. 3 Subset of emerging market economy with lower market capitalizations and liquidity that offers plenty of opportunities to generate higher excess returns for investors. Sources: IMF, Worldbank

3 Copyright 2012 SMU Economics Intelligence Club

Is the US Natural Gas Glut Set to Continue?

By Andrew Tan, Columbia University
"[The global energy map] is being redrawn by the resurgence in oil and gas production in the United States." -Energy Information Authority In November 2012, Paris based EIA released World Energy Outlook, a report predicting energy independence for the US in 2030, and the US as the top oil-exporting nation by 2020. From out of nowhere, the US has joined leading oil-producing nations like Russia and Saudi Arabia. This is thanks to recent advances in horizontal drilling and hydraulic fracturing. Increased production has not only occurred in both traditional oil producing states like Texas, but also states not previously known for oil production such as Pennsylvania, Oklahoma, and North Dakota. On the back of new shale rock extraction techniques, the oil & gas industry, which supports almost 10 million jobs in the US and contributes to 7.7% of GDP, is set to continue its robust growth. In 2012, economic forecaster HIS global insight estimated that an incredible 1.7 million jobs were created by the oil & gas industry. The Last Five Years The biggest story of the last 5 years has arguably been that sudden supply of cheap natural gas. Natural gas is comparatively difficult to transport and is therefore not traded on global markets. This is responsible for dramatic decreases in NYMEX natural gas prices. In other words, domestic production equals domestic supply. On the contrary, crude oil is traded in global markets and prices have remained largely constant because US production is still only a fraction of the global supply. The two graphs below illustrate the consistent decrease in natural gas prices since 2008, and the increasing spread between NYMEX crude oil and natural gas prices. These trends look set to continue the U.S government expects that prices will remain below $5 for another decade. Figure 1: Decrease in Natural Gas Prices since 2008

Source: Consumer Energy Solutions 4 Copyright 2012 SMU Economics Intelligence Club

Figure 2: Increasing Spread between NYMEX Crude Oil and Natural Gas Prices

Source: ICIS

So far, the main impact of cheap natural gas in the US has been for domestic electricity production. Coal fired plants are being closed in favor of natural gas fired plants at a rapid rate. From 2007 to 2012, electricity generation from Coal has decreased by 25% while Natural Gas increased its contribution to 35%. The Future of Natural Gas Exports Figure 3: December 2012 Spot Price ($mmBTU)
16 14 12 10 8 6 4 2 0 US UK Belgium (EU) India China South Korea/Japan

Source: Federal Energy Regulatory Commission In the near term, the biggest question on everyones mind is whether the US will export natural gas. As the chart above shows, natural gas prices in other countries (especially Japan) are several times higher than in the US. Japan, which has relied on expensive Liquefied Natural Gas imports for electricity production in the wake of the Fukushima nuclear plant incident, would be a prime candidate for US gas exports. 5 Copyright 2012 SMU Economics Intelligence Club

However, even as domestic producers are priming themselves to export gas, the US government has shown reluctance to grant export permits1 because of political pressures to keep prices low for consumers, domestic manufacturers, and the petrochemical industry. Only one firm, Cheneire Energy, has received approval to export Liquefied Natural Gas (2 billion cubic feet/day) and has started building a multi-billion dollar Liquefied Natural Gas terminal in Sabine Pass, Louisiana. More than ten other firms are waiting for the governments approval and have applied to export a total of 27.58 billion cubic feet/day to countries with a free trade agreement2, which is more than the current entire output of US shale gas. My view is that exporting natural gas is not the sure arbitrage3 opportunity that many would have you believe. Unlike exporting oil, there are large costs involved in processing and transporting natural gas. Liquefaction, shipping, and terminal costs are likely to add $3.80 and $5.76 to the price of gas exported to Europe and Japan respectively. This more than doubles the price that natural gas trades at in the US today. Furthermore, with natural prices likely to hover around $5 when export terminals begin to come online in 2015 and price of WTI crude to come down to about $80 (more in line with historical ratios), the margins look increasingly small. In Europe, natural gas supplied by pipelines from Russia will provide serious competition to American imports. Exports are still likely, particularly to Asian countries like Japan who will want to tie down long-term contracts for natural gas. Potential Rust Belt Revival One interesting development in the US is the return of rust belt manufacturing and industrial firms. Companies like Shell have started to explore the option of building multibillion dollar chemical plants which use natural gas as feedstock to produce fertilizers and chemicals near natural gas wells in Pennsylvania (home to the Marcellus shale which currently has the lowest cost of production and liquid rich gas). Energy intensive industrial activities like aluminum smelting are also options that companies are hoping to establish near gas-producing regions. Will production continue to increase? Shale gas is hailed in many quarters as the key to American energy independence and a game changer for the US economy. After all, the growth in natural gas production over the last few years has heavily relied on shale rock plays, which currently represent approximately 30% of all gas production. However, even as large investments were made in 2012 foreign oil majors like Frances Total and Norways Statoil in US Shale-rock formations, shale gas production began to plateau in early 2012, and there are signs that its potential may be overstated. Stagnating production levels are mostly due to record low gas prices. At $3, it is unprofitable to extract natural gas from almost every known gas field. Many shale gas operators are drilling at below the $5 to $6 necessary to break-even (costs also include leasing, exploration, and development). Furthermore, simply keeping output constant requires constant exploration and production because well output decreases by about 50% after one year. At the same time, overstated shale gas well productivity casts doubt upon claims that there is a proven 100 year supply of natural gas in the US. The first problem is that shale gas extraction is relatively new and there are few credible models about extraction volumes in the 6 Copyright 2012 SMU Economics Intelligence Club

long run. Producers often report initial extraction flow rates instead of average ones, or estimate longer life spans for wells than is likely. Furthermore, US Energy Information Administration data shows that there is only 11 years worth (at current consumption) of gas in proven reserves. The rest of it is from probable, possible, and speculative resources.
1 A legal document that is necessary for the export of goods controlled by the

government. 2 A treaty between two or more countries to establish a free trade area where commerce in goods and services can be conducted across their common borders, without tariffs or hindrances. 3 Taking advantage of a price difference between two or more markets.

Sources: Consumer Energy Solutions, Factset, Federal Energy Regulatory Commission, ICIS, Forbes, PFC energy, WSJ Analysis

7 Copyright 2012 SMU Economics Intelligence Club

Chinas much needed economic reform

By Wong Shou, Singapore Management University
Finally, the global economic crisis has taken a toll on Asias biggest economy. The ongoing Europe debt crisis and the weakening American economy have hampered Chinas export market, contributing to its decreasing GDP growth rates over 7 consecutive quarters. Chinas declining performance (9.8% y/y increase in GDP in 1Q11 to 7.4% in 3Q12), along with its vulnerability towards external shocks has set alarm bells ringing. To better shelter the country from the overseas brewing storms, China recognizes that it needs to rebalance its economic structure. This reform will see its economy shift from one that relies heavily on investment and exports, to one thats driven largely by domestic consumers - and its new leaders have to act fast. Figure 1: Chinas Activities as a Percentage of GDP
50% 40% 30% 20% 10% 0%

2001

2003

2005

2007

2009

2011

Investment

Consumption

Net Exports

Source : CEIC Domestic consumption has been on a downtrend, and in 2011, it accounts for only a mere 34% of Chinas GDP. Chinas low consumption and high level of investments highlight the internal imbalance that is currently plaguing the country. The Chinese leaders have long acknowledged this fundamental problem and discussions have taken place within the party to implement policies to develop a more market-oriented economy. This is, however, a big challenge for the country, as we have seen some resistance from political figures and business elites to prevent losing the current model that has benefited them well over the years. Overinvestment in Gross Capital Formation in China At 48%, Chinas investment as a percentage of its GDP is exceptionally high relative to both the developing BRIC countries and leading developed nations. The two main factors behind its high level of gross capital formation in China can be attributed to the role of state-owned enterprises1 (SOEs), as well as its over-reliance on infrastructure investment.

8 Copyright 2012 SMU Economics Intelligence Club

Figure 2: Gross Capital Formation as a percentage of GDP by countries (2011)

Gross Capital Formation (Investment) as a % of GDP (2011)

50% 40% 30% 20% 10% 0%

China

Russia

India

Brazil

Germany

Japan

United Kingdom

United States

World Average

Source: Worldbank Role of SOEs in China China is known to be a government led economy, where a few powerful SOEs dominate in their respective sectors. According to Nomura Bank, these SOEs employ about 21% of the workforce, produced 27% of industrial output, and control a massive 44% of capital stocks, despite accounting for only 4.7% of the total number of firms in the country. Not only do they receive huge subsidies from the governments, the financial system also provides them with preferential credit terms, giving them access to cheap capital to fuel their insatiable appetite for capital investments. The authority and power of these SOEs have to be scaled down, and suggestions have been made to increase the required dividend payouts from these companies. This is, however, easier said than done given that the past decades of capital cronyism2 and nepotism have complicated the relationship between the government and SOEs. Whether China can successfully overhaul this inefficient model ultimately depends on the political stomach of its new generation of leaders, and many observers will be monitoring the leadership of Xi Jinping in the upcoming years. Over-reliance on Infrastructure Investment As a response to the global economic crisis in 2008, the government implemented a RMB 4 trillion (USD 586 billion) stimulus package, of which 38% of it went to public infrastructure investment. Further exacerbating the imbalance is the fact that the big commodities, transportation and construction companies who benefited from this stimulus are mostly SOEs. In Sep 12, with the outlook looking grimmer and the imminent risk of a hard landing, the Chinese government announced an additional RMB 1 trillion (USD 160 billion) worth of infrastructure investments. Despite Chinas high reliance on investments, capital formation will be likely to continue its growth as the country accelerates its infrastructure projects to support it rapid urbanization process. Further, with global economic conditions unlikely to improve in 2013, China is expected to continue its infrastructure investment as a mean to 9 Copyright 2012 SMU Economics Intelligence Club

drive its economy. Unfortunately, it seems like Chinas rebalancing priorities will be taking a backseat yet again. Consumption as a main source of driver Figure 3: Consumption as a Percentage of GDP by Countries (2011)

Consumption as a % of GDP (2011)

80% 70% 60% 50% 40% 30% 20% 10% 0%
China Russia India Brazil Germany Japan United Kingdom United States World Average

Source: Worldbank data With the largest population in the world, its hard to fathom how 1.3 billion people consume only 34% of the countrys GDP. Part of the reason is due to the countrys ill-equipped social welfare system that has forced households to increase their precautionary savings for future expenditure. On top of that, Chinas immature financial system provides only stingy returns on investments, and its xenophobic policies have limited competition within the economy and a misallocation of resources skewed highly towards local firms. All these factors have played a part in increasing domestic savings as well as suppressing the potential growth of household disposable income - the two main reasons behind the countrys declining consumption. Fortunately, the required reforms to empower the Chinese households face fewer headwinds, and the government has been actively unraveling plans to liberalize the financial system, increase foreign involvement in the private sector, and restructure the social system. For instance, China has pledged to allow foreign firms to increase their stake in Chinese financial service firms from 33% to 49% to introduce more competition in the securities sector. Other policies that are in the pipeline include an approval to increase minimum wage at an annual growth rate of 13% until 2015. Such initiatives will certainly see domestic consumers benefiting from a more competitive and market-oriented economy, where higher disposable income and a lower propensity to save will translate into higher consumption. Challenges and outlook At a time where the need for economic reform is ever more so important, China still faces two inherent challenges in this endeavor. First, the political reluctance and difficulties that officials face in their attempt to restructure the SOEs and redefine their roles. Second, the increasing infrastructure investment amidst the bleak economic conditions and rapid urbanization process. It is likely that investment spending will continue to remain high in the short term as 10 Copyright 2012 SMU Economics Intelligence Club

China continues to fend itself against the adversity of the global economic crisis. As long as investments do not taper off, the goal of achieving a consumption driven economy remains quite a distance away even if consumers are increasing their spending. Ultimately, consensus among the Chinese leaders will determine the overall direction the economy is heading towards. With a new leader at the helm of the party, political observers are confident that Xi Jinping will embark on this economic overhaul something his predecessor has failed to accomplish. However, the new reign has only just begun, and stronger and more positive signs have to be witnessed before the economic intentions of the new generation of leaders can be ascertained.
1 A legal entity that is created by the government in order to partake in commercial activities

on the government's behalf. 2 An economy in which success in business depends on close relationships between business people and government officials. It may be exhibited by favoritism in the distribution of legal permits, government grants, special tax breaks, or other forms of dirigisme. 3 China's rapid economic growth in recent years has often given rise to speculation about the possibility of a hard landing, in which the economy slows down from a double-digit rate to a growth pace in the low single digits. This could occur if measures by the Chinese government to tighten monetary policy slow down growth faster than it expects, or would like.

Sources: Wall Street Journal, New York Times, China 2030 World Bank Report

11 Copyright 2012 SMU Economics Intelligence Club

 The S&P 500 is a free-float capitalization-weighted index published since 1957 of the prices of 500 large- cap common stocks actively traded in the United States. It has been widely regarded as a gauge for the large cap US equities market The MSCI Asia ex Japan Index is a free float-adjusted market capitalization index consisting of 10 developed and emerging market country indices: China, Hong Kong, India, Indonesia, Korea, Malaysia, Philippines, Singapore, Taiwan, and Thailand. The STOXX Europe 600 Index is regarded as a benchmark for European equity markets. It represents large, mid and small capitalization companies across 18 countries of the European region: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the United Kingdom.

Correspondents Vera Soh (Vice President, Publication) Jia Wei Ng (Vice President, Operations) Vera.soh.2011@economics.smu.edu.sg Jiawei.ng.2012@economics.smu.edu.sg Singapore Management University Singapore Management University Singapore Singapore Samuel Ong (Publications Director/ Editor) Shreya Chatterjee(Marketing Director) samuel.ong.2010@business.smu.edu.sg shreyac.2010@economics.smu.edu.sg Singapore Management University Singapore Management University Singapore Singapore Yingyu Zeng (Liaison Officer) Darren Goh Xian Yong (Editor) Yingyu.zheng.2010@economics.smu.edu.sg Darren.goh.2010@business.smu.edu.sg Singapore Management University Singapore Management University Singapore Singapore Adam Tan Kian Hung Wong Shou Yee adam.tan.2009@business.smu.edu.sg sywong.2010@business.smu.edu.sg Singapore Management University Singapore Management University Singapore Singapore Andrew Tan Alt2140@columbia.edu Columbia University New York Everything in this document and/or in this website is copyrighted by law and cannot be used without the written permission of its owner/publisher. It is forbidden to make digital copies or reproductions, however you may however use the information as reference material and it may be physically printed for personal use. You may also quote parts of the content of this publication, digitally or physically, if the source and author is clearly stated, together with the copyright information. All views expressed in this publication are the personal opinion of the researcher(s), do not constitute a buy or sell recommendation on any instruments, and in no way reflect the opinions, views, or thoughts of SMU and other abovementioned universities, and unless specified, of any other student clubs. All logos and/or images on these pages belong to SMU and the respective third party copyright and trademark owners. SPEX, affiliated clubs and the covering researcher accepts no liability whatsoever for any direct or consequential loss arising from any use of this document or further communication given in relation to this document. SPEX is the brainchild of current New York University undergraduate Mr. John Ang, further developed by SMU students for the benefit of both SMU and non-SMU students.

12 Copyright 2012 SMU Economics Intelligence Club