SMU Political-Economic Exchange

AN SMU ECONOMICS INTELLIGENCE CLUB PRODUCTION

- Of Enforcing Punishment and Honouring Promises: A Tale of the European Monetary Union - A Challenging Journey for the Fledgling Economy - Perils of a Dollarised Cambodian Economy (Part 2 of 2) The Fortnight In Brief (28th August to 10th September) US: Poor Economic Figures Rain on Democratic National Convention There is little cause for celebration at the Democratic National Convention as the Institute for Supply Managements index fell for the third straight month, confirming the weakness of American manufacturing. The news bolsters the Republican campaign as they ask the American people if they are better off than they were 4 years ago. Furthermore, the poor figures also raise the probability of more aggressive monetary policy to support the US recovery. Asia Pacific ex-Japan: We are all going South Indias economic growth slipped to its lowest in three years. The 5.5% growth between April and June was slightly better than the first three months of 2012 but persistent inflationary pressures and high interest rates have weakened consumption and brought investment growth down close to naught. However, Asian stocks rallied following the ECBs announcement on 7th September to buy up troubled European bonds. Chinas announcement about plans for more infrastructure spending also encouraged the celebration in Asian markets. Chinas 1st September Value Added Tax (VAT) Reform is also expected to reduce tax burden on small and medium businesses and boost the weak Purchasing Managers Index. Major trading indexes like the Shanghai Composite, Hong Kongs Hang Seng Index, South Koreas Kopsi and Australias S&P/ASX 200 index all headed south by the end of the week. EU: ECB, the preferred creditor? The ECB recently announced a new program of bond purchases for eurozone members whose sovereign spread are not justified by fundamentals. The new program is likely to occur in the 1-3 year maturity range as the ECB hopes that private investors will feel encouraged to invest alongside it and lower long-term yields. The ECB will face an immense challenge convincing investors that it will not act as a preferred creditor, as it did in the Greece bailout. France's unemployment rate rose to 9.7% in Q2 2012, the highest in 3 years, while the EZ crisis finally hits Germany's services Sector, as Germany's services PMI registered 48.3 in August, significantly down from 50.3 in July.

ISSUE 24 10 SEPTEMBER 2012

IN COLLABORATION WITH

PROUDLY SUPPORTED BY

Of Enforcing Punishment and Honouring Promises: A Tale of the European Monetary Union
By Jonathan Muk, Singapore Management University
This article looks at how the failure of the EU in honoring its promises and enforcing punishments has resulted in the euro debt crisis, and why it is important for promises to be kept and punishments enforced Of bailouts, broken promises, unenforced punishments. Such is the story of the Euro currency, its creation so optimistic until the 2007 United States property bubble collapse and the subsequent Greek woes. Nevertheless, unlike naysayers and despite the bleak economic conditions in Europe, it is unlikely that the Euro will collapse for one very fundamental reason European solidarity. The story of the European Union (EU) currency is really not as complicated as it seems. The legal instrument that gave birth to the common currency the Maastricht Treaty1 contained provisions that 1) limited a countrys public sector deficit to 3% maximum and 2) limited total public debt below 60% of GDP. However, the reality that eventually cumulated into the Euro currency crisis was that these countries often violated the rules, the main culprits initially being France and Germany, which then lacked the moral authority to sanction other violating states. The situation was worsened by the revelation in 2008 that the Greek government had previously falsified government records in order to gain admission to the common currency. This resulted a loss of market confidence and the realization that Greece could potentially default on its debts with the European Central Bank (ECB) not willing to be the lender of last resort. Subsequently, Greek borrowing costs skyrocketing and there was a loss of confidence in other deficit countries, resulting in bailout packages to be issued to Greece, Portugal, Ireland and Spain. As part of the bailout package, recipient countries have had to commit to fiscal reduction targets set by the ECB to ensure the long-term viability of the common currency, which as shown above, require the countries to adopt a common monetary policy and subject to fiscal limitations. To combat the crisis, the ECB has established the European Financial Stability Facility2 (EFSF) and the European Financial Stabilization Mechanism (EFSM) as programmes to provide shortterm relief to distressed European nations. For the longer term, the European Stability Mechanism3 (ESM) is intended to replace both the EFSF and EFSM. The emphasis on fiscal discipline has also been strengthened, with a fiscal pact being agreed on and signed by 25 EU member states, with the United Kingdom and the Czech Republic abstaining. It is expected however that the abstinence by these two countries will be immaterial due to their exclusion from the Euro currency and consequent greater autonomy with regards to monetary and fiscal policies. While the funding mechanisms are instrumental in providing short-term stability to the Eurozone, longer-term reforms will be crucial in ensuring that governments continue to be able to meet the requirements under the Maastricht Treaty. Presently, it is noted that despite austerity measures, public debt-to-GDP ratios (figure 1) continue to rise for virtually all 2 Copyright 2012 SMU Economics Intelligence Club

European nations, indicating continued violation of the Maastricht Treaty. What this indicates is that to ensure the survival of the Euro, European nations will have to continually borrow from international markets to fund continued budget deficits, inter alia. Unless, somehow, ways to run a budget surplus can be found. However such a discovery may prove to be elusive, for the following reasons.

Figure 1: Debt to GDP Ratio Source: CIA World Factbook Data First, under the common currency, the ability of most distressed nations to compete economically with the rest of the world has been restricted. While countries like Greece, Italy and Spain desire a depreciation of the Euro against other currencies for export competitiveness, such a desire is absent in Germany where there is strong economic growth as opposed to recession in most of South Europe. However the common currency and the acceptance of bailouts also meant that for these countries, their hands are tied they neither have the monetary autonomy to depreciate their own currency nor the fiscal ability to keep borrowing from international markets as borrowing costs soar. Consequently, public debt continues to rise as exports stagnate, domestic consumption decreases and economic growth continues to slow, as seen in 2012s second quarter economic contraction of 0.2%. Economic growth in many European countries also continue to be hampered by minimum wage laws and welfare policies that dis-incentivize hard work and investment. As commented by former Malaysian Prime Minister Mahathir Mohamed, European workers are overpaid and underproductive, leading to a consequence outsourcing of jobs to cheaper destinations in Asia. Due to a lack of job creation, workers from these regions continue to emigrate for job opportunities elsewhere and Germany in particular has seen an influx of skilled labour from Spain, where according to the Guardian, the jobless rate has hit nearly 25% this year. Such 3 Copyright 2012 SMU Economics Intelligence Club

emigration consequently worsens the fiscal situation for the governments of these nations as brain drain exacerbates and the investment climate worsens, leading to less investment and more unemployment. The fiscal position is also not helped by the collapse of property market bubbles in Europe. As seen in the distressed nations of Ireland, Greece and Spain, which over-relied on the property market for taxes, tax revenue fell between 0.4% to 0.6% of GDP between 2008 and 2010 when the bubble collapsed. One must note that 2008 tax revenues had already fallen 1% from their peak in 2006. Lastly the crisis exacerbates relations between countries. While Germany demands austerity, recipient countries continue to insist their countries are being made victims of the crisis and continually call for less austere measures and solutions to the crisis. Such requests however are unlikely. At least not in the face of governmental inability to carry out much-needed labour market reforms, tax reforms or use monetary/fiscal policy to boost anaemic economic growth. Whether such reforms will actually take place is highly questionable, since the removal of welfare benefits, minimum wage laws and restructuring of labour laws are politically unpopular and often met with massive strikes and successive governments sworn in and out of power, which in turn complicate negotiations at the international level. For the above reasons, the EFSF, EFSM and ESM are likely to plaster over deeper structural and societal problems. One also cannot help but wonder how is it possible to sanction a country and expect obedience without the threat of military invasion. How is it possible that countries abide by financial sanctions imposed on them without some sort of enforcement mechanism? It is noted that for the distressed countries, financial sanctions are enforced by giving the bailout money only if the countries abide by certain targets. If these countries do not meet the targets, the EUs governing body might decide not to release the money. However one must note that the fate of the Euro involves not just these distressed countries, but also the fate of all the countries in common currency area. The withholding of aid money is thus unlikely and it is thus likely that the fiscal pact signed by European nations could amount to nothing but an empty promise, just like the Maastricht Treaty 12 years earlier. Nevertheless, despite the abovementioned problems, it is unlikely that we will see the demise of the Euro. After all, one of the key considerations in forming the Euro was European solidarity. Any moves to eject a country from the common currency could spook fears among other nations that they would be next and put an end to this overriding political objective. In this light, former French President Nicolas Sarkorzy and German Chancellors vows to defend the Euro seems to make sense. The Euro crisis has taught economists many lessons. But perhaps the two most vital lessons one can learn from this crisis are: 1) promises must be kept and 2) punishments must be enforced.
1

The 1999 treaty that was signed between the Eurozone nations that gave birth to the Euro currency.

A mechanism to safeguard financial stability in Europe by providing financial assistance to EU member states through the issuance of bonds and debt instruments, with a total lending capacity of 440 billion.
2

A mechanism that provides funding to the European Commission up to 60 billion on behalf of the European Union for financially distressed EU member states.
3

Sources: Bloomberg, Times, and International Economics by Paul Krugman 4 Copyright 2012 SMU Economics Intelligence Club

A Challenging Journey for the Fledgling Economy: Important things that Myanmar needs to be aware of in order to speed up development
By Myat Thiha Kyaw, Singapore Management University
Although it has been nearly two years since Myanmar started to open up her economy, the progress has not been as fast as predicted by some experts. Due to the lack of good infrastructure in the midst of political instability and weak legal enforcement, many foreign investors have yet to enter the country and most of them are still observing the economic and political situation in Myanmar. While it might probably be with the cautious optimism or healthy skepticism which Daw Aung San Suu Kyi referred to at the World Economic Forum in Bangkok in May 2012, the officials and the people of Myanmar should also try to adapt and get ready for change. There are three main considerations for businesses and foreign investors to contemplate before entering Myanmar. The first is the lack of good infrastructure and a skilled workforce. The second is the weak enforcement of legislation and corruption that is still present in the government. The last consideration is the political instability and recent violence in the western and northern parts of Myanmar. Myanmar would definitely need better infrastructure and basic facilities, such as a reliable electricity and water supply, in order to be an attractive place for businesses and investments. Myanmar is a country rich in energy resources such as petroleum, oil and gas. However, many parts of Myanmar are still short of electricity, even in big cities like Yangon and Mandalay, where households and businesses cannot get sufficient electricity for daily use. Therefore, almost all businesses that use electricity would need to incur more costs to run their own generators to get electricity. This naturally drives up production costs for businesses, making Myanmar unattractive for investment. Moreover, other public infrastructures, such as roads and drainage systems would also need to be improved in the main commercial cities. The recent lifting of import taxes for automobiles means that the poorly maintained roads in Yangon and Mandalay have to serve a surge of automobiles. These cities are suffering from higher transport costs as road density is 2 kilometers per 1,000 people, which is much higher than the average in Southeast Asia of 11 kilometers per 1,000 people. Moreover, as Myanmar is a monsoon country, there are also urban floods due to heavy rains and poor drainage systems during the rainy season. These weaknesses in infrastructure are one of the main reasons for the reduced amount of foreign investments in Myanmar. In addition to the lack of infrastructure, the scarcity of highly skilled professionals and engineers is also a factor in the slowing of Myanmars development. The many years of military junta leadership and an economy ruled by cronies caused the business and government sectors to fail to supply suitable jobs for many educated youths. Although the unemployment rate of Myanmar is not considerably higher than its ASEAN neighbors as shown in Figure 1 below, there are many underlying reasons for the small difference between Myanmar and its neighboring countries in terms of unemployment. Throughout the years of tyranny and the lack of jobs, many of the young and educated had migrated to support their families and improve their living standards. Therefore, Myanmar suffers a considerably large brain drain1 to its ASEAN neighbors as well as to western countries such as the United States. As it had lost many people with technical skills and knowledge, Myanmar would need to entice them home in order to be appealing to foreign businesses and investors. 5 Copyright 2012 SMU Economics Intelligence Club

Figure 1: Unemployment rate in selected ASEAN countries

Unemployment Percentage of Labour Force 12 10 8 Myanmar 6 Thailand 4 Vietnam 2 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Year
Source: CIA World Fact Book

Singapore

The lack of transparency and strict enforcement is another contributing factor of lesser than expected foreign investments in Myanmar. Nearly five decades of tyranny and a poorly developed education system have corrupted the system from the root to the branches of government offices. It would be hard for many businesses to operate and be formally established in Myanmar unless she can eradicate the corruption troubling her people everyday. Moreover, there is a debate in Myanmar about giving tax incentives and subsidies for Foreign Direct Investments (FDI). One danger is that if Myanmar imposes protectionist measures to exclude foreign investors from particular sectors, it would not only result in deadweight loss2 in terms of not allowing comparative advantage3 to allocate resources in these sectors, but also create less incentive for innovation due to the lack of foreign competition. Therefore, it would be extremely harmful for Myanmars development process should there be any protectionism against foreign investments. In addition, restricting foreign investments to cooperatives such as local partnerships or joint ventures would also have the same harmful effect of slowing down development. If foreign investments operate only as local partnerships or joint ventures, the multi-national companies (MNCs) with advanced technologies may bring in less important and sophisticated technologies for fear of intellectual theft. Therefore, Myanmar would suffer the same effects as under protectionism if she imposes mandates on foreign multinationals to design their own production processes. As a fledgling democratic country, Myanmar experienced recent conflict and instability among the communities on the western and northern states. Although these conflicts were never likely to spread to the central cities or other parts of Myanmar, there is a considerable anxiety and consciousness among the international community about safety and security if they were to go to the commercial cities of Myanmar for visits or on business. Of course, political, social and economic stabilities are the most important concerns for businesses and investors. Most investors would choose a more secure country to operate in rather than one that is in chaos. Therefore, the government of Myanmar should be prepared to come up with a quick and 6 Copyright 2012 SMU Economics Intelligence Club

reliable response in order to guarantee the safety of businesses from not only social conflicts but also economic and political instabilities. Myanmar is not as urbanized as many Asian countries, and there is still a considerable gap for Myanmar to catch up to neighboring ASEAN countries. As we have witnessed throughout the 20th century through examples like Japan, Hong Kong and China, the catch up process is accelerating as more advanced technologies and faster communication systems become available. However, this is only if the process is done in the appropriate and efficient way. Therefore, Myanmar should be well prepared and make sure that the government and its people are the main driving forces of development in order to capture foreign investments which are crucial for the nations economic development.
1

The emigration of highly trained or intelligent people from a particular country

Costs to society resulting from inefficient allocation of resources in the market or when supply does not meet demand
2

The situation in which an entity can produce a good or service at a lower opportunity cost than a competitor
3

Source: Asia Development Bank, CIA World Fact Book

7 Copyright 2012 SMU Economics Intelligence Club

Perils of a Dollarised Cambodian Economy (Part 2 of 2)

By Eugene Lim, Singapore Management University
In the previous issue, we examined the unusual phenomenon of Cambodia becoming increasingly dollarized albeit better economic performance and also some of the effects of this dollarization namely: loss of autonomy in steering the economy, an underdeveloped financial sector and unavailability of microfinance funds. The second part of the essay will address how these effects from dollarization impede on the poors well-being.

Figure 1- Ratio of USD to monetary bases of selected countries Combining a loss of autonomy to conduct monetary/exchange rate policy with an underdeveloped financial infrastructure, the poor are in direct exposure to exogenous shocks because both the authorities and the people lose the capability to mitigate the consequent negative effects. As shown in figure 1 above (and discussed in Part 1 SPEX Issue 23 of this article), one can easily notice the dollarisation effect in the Cambodian economy is more prevalent than other economies in similar stages of development. On top of that, there is a glaring absence of a formal social safety net in Cambodia. In a joint report by the Council for Agricultural and Rural Development (CARD) and other developmental organizations, it was highlighted that in 2004, a mere 10 percent decline in the per capita income would plunge an additional 7 percent of households into poverty. Exogenous shocks can come in the form of inflation and volatility of prices for key goods such as agricultural products. Dollarization has also led to a lack of funding available to the poor. The associated negative repercussions act as three different forms of impediment on the poors pursuit of well-being and progress; erosion of purchasing power, reduction of income and constraint on progress. The first impediment comes in the form of inflation eroding the purchasing power of the poor for amenities such as food and healthcare. For example, responding to the recent global 8 Copyright 2012 SMU Economics Intelligence Club

finance crisis, the U.S. Federal Reserve decided to run an expansionary monetary (through rounds of quantitative easing) at a time when Cambodia required tightening so as to curtail growing inflationary pressure. As a result, the year-on-year consumer price inflation (with food inflation rate as the main contributor) was kept stubbornly high at over 22 - 25 percent throughout 2008. Price hikes in terms of nominal earnings meant that the poor had to adjust accordingly by aggressively reducing their consumption of food. Due to skyrocketing food prices (e.g. price of rice doubled from March 2007 to March 2008) and given the fact that the poorest of the poor was already spending 83 percent of their total consumption on food previously, many of the poor suffered from hunger and malnutrition. The government was not able to provide much help due to a weak fiscal position and many, such as those poor and vulnerable to falling below the poverty line were reliant on the World Food Programme (WFP) for food aid. The other main concern of the poor is healthcare. As a result of a depreciating riel against the dollar and Cambodia importing most of its medical supplies, inflation in healthcare cost hit 21 percent in 1997. The poor, who transacted in riel, were the most severely affected and were virtually denied of accessibility to healthcare. Inflation, brought about by loss of autonomy of managing the economy, threatened the basic survival of Cambodians. The second impediment is the income reduction of the poor in the face of prices and demand volatility. In the face of an underdeveloped financial sector, the poor are ill equipped to manage such volatility. In the rural economy, there was a heavy reliance on agriculture, which accounted for 35% of GDP in 2009 and employs half the workforce. This meant that the income of majority of the poor was susceptible to the volatility of prices and exchange rates. In this case, the rural poor did not have the technical know-hows and options of safeguards such as hedging - a financial instrument to reduce the risk and potential loss from negative shocks. Without such safeguards, uncertainty due to external conditions will continue to plague rural agriculture producers. For example, a sudden drop in the demand or price of their products can leave the producers with unsellable surplus or diminished incomes respectively. Education, often seen as the main ticket for upward social mobility, is one of the first to be abandoned in the face of reduction of income. Although the rural economy is relatively sheltered from the issues of price bubbles and real estates booms due to the absence of dollarization and access to financial institutions, this also means that the capacity of the rural poor to borrow money so as to accumulate wealth and opportunities for upward social mobility are limited. The third impediment is the constraint on progress vis--vis unavailability of microfinance funds. The majority of business enterprises in Cambodia, which are usually small-scale, secure little funding from commercial banks due to the absence of microfinance loans that is usually the more suitable source of funding. Small-scale businesses and production owned by the poor often face short-term cash flow issues. The unavailability of microfinance funds to tide over small pockets of difficult times (given the volatility of the business and production climate in Cambodia) is often detrimental and disruptive to both development and pursuit of the well-being of those affected. For example, since rice production is a major part of the rural agricultural activities, rice paddies are key assets. Often, due to debts, paddies have to be sold at low price and milled rice (for consumption) is bought back with greater cost. Thus, due to a small cash-flow difficulty, the rice producer suffers a double setback through a loss of his source of revenue and incurred greater cost. It is also likely, in a bid to survive, that the rural poor (particularly the landless) would fall deeper into debt traps by taking up new loans with high interest to pay off existing debts. Therefore, instead of breaking out of the poverty cycle through gradual progress, the lack of microfinance funds denies the poor the resources to do so. 9 Copyright 2012 SMU Economics Intelligence Club

Conclusion In the last few decades, Cambodias economy underwent a rapid transformation through high growth, large increase in per capita income and reduction in poverty rate. However, the trend of becoming increasing dollarized due to the opening up of the economy and a dual track economy poses a threat to the poor and vulnerable. The authorities have not been able to manage the economy efficiently and develop a financial sector, all of which adversely affects the poor. Susceptible to high inflation rates, those living in poverty are faced with the danger of hunger and malnutrition. Even if some manage to survive based on limited subsidies and aid, there are few avenues available for the poor to break out of the poverty circle as the financial sector and in particular, the microfinance industry are constrained from providing loans. Other known threats to the poor include the rising income regional inequality and reduction of purchasing power of the riel vis--vis the USD. Inherently there is a need for the Cambodian government to de-dollarize the economy and encourage the usage of riel. There has also been calls for a more inclusive growth through equal access and opportunity and increased protection for the poor and vulnerable. Yet, such proposed measures have to be carried out at a well-calibrated pace to avoid economic and social instability. To ensure continuous progress and better welfare of the people, especially the poor, Cambodian authorities have to be more prudent in the direction and implications of their policies.
1 Government

programmes that protect the poor and vulnerable from falling below a minimum standard of living
2 The

fluctuation of demand forces, which in turn affects price levels monetary policy of increasing money supply in the economy

3 Government

Sources: Council for Agricultural and Rural Development, Economist Intelligence Unit, The World Bank, United Nations Database (Cambodia).

10 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 Ben Lim (Vice President, Publication) ben.lim.2010@smu.edu.sg Singapore Management University Singapore Tan Jia Ming (Publications Director) jiaming.tan.2010@smu.edu.sg Singapore Management University Singapore Vera Soh (Liaison Officer) Vera.soh.2011@economics.smu.edu.sg Singapore Management University Singapore Seumas Yeo (Editor) Seumas.yeo.2010@smu.edu.sg Singapore Management University Singapore Eugene Lim eugene.lim.2008@economics.smu.edu.sg Singapore Management University Singapore Herman Cheong (Vice President, Operations) Wq.cheong.2011@economics.smu.edu.sg Singapore Management University Singapore Fariha Imran (Marketing Director) Farihaimran.2010@economics.smu.edu.sg Singapore Management University Singapore Randy Lai (Editor) Tw.lai.2010@smu.edu.sg Singapore Management University Singapore Jonathan Muk jonathanmuk.2008@law.smu.edu.sg Singapore Management University Singapore Myat Thiha Kyaw tkmyat.2010@business.smu.edu.sg Singapore Management University Singapore

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