SMU Political-Economic Exchange

AN SMU ECONOMICS INTELLIGENCE CLUB PRODUCTION

ISSUE 7 19 December 2011

- The economic implications of natiionalization (Part 1) - Divided We Stand, United We Fall - Are we creating another tech-based bubble?

The Fortnight In Brief ( 5 December to 16 December )

US: False Dawn? While employment seems to be picking up, the non-manufacturing sectors (which covers almost 90% of the economy) paints a less rosy picture with the ISM NMI registering the lowest read since January 2010. Meanwhile, the trade deficit continues to narrow as demand for petroleum imports lowers. The Fed continues to stress that the fed funds rate will remain at low levels as long as unemployment and inflation stays within stipulated thresholds. EU: Same Story, Different Day Once again, the Dec 9 EU Summit failed to lift the spirits of global markets. With Britain unwilling to forge a deeper monetary union with a new union-within-a- union comprising France, Germany and 21 other countries, a new rift is exposed in the EU that threatens to once again prevent further consolidation from taking place. The lowering of the ECB benchmark interest rate of 25 basis points to 1 percent signals the willingless of the central bank to offer cheaper credit to borrowers and businesses in order to increase optimism on the blocs crises- fighting abilities. However, market reaction was lukewarm at best as bond yield on Italian and Spanish bonds pushed higher following the announcement. Asia Pacific ex-Japan: Slower Growth Ahead Asian economies are reflecting a disinflationary trend (ie. slowing inflation growth), with Chinas property market in the spotlight now. With declining real estate transactions, overleveraged developers are forced to cut prices to stay afloat amidst mounting debt oblifations. The overall slowdown of Chinas economy will ultimately affect its trading partners as demand from this major global engine of growth recedes. With Chinas FDI contracting for the first time since 2009, coupled with the Eurozone crisis, the negative outlook instigated the outflow of capital and the consequent pressure on several currencies- the IDR, MYR and KRW among them has led to central banks intervening to stabilize their currencies.

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What are the Economic Implications of Nationalization?

By Lisa Ho, Singapore Management University The first of two, this article examines the debate over nationalisation of South Africas mines, and considers the general arguments in favour of nationalisation. Part Two discusses the possible domestic, regional and global impact of such a move, and concludes that nationalisation would not be a wise strategy. Part One For the past couple of years, South Africa has been engaged in a debate over nationalising several sectors of its economy, including the South African Reserve Bank and agricultural land. This article will discuss nationalisation in the context of South Africas mining industry, as this has proven to be the most contentious area thus far. What exactly is nationalisation, and what are the possible impacts of nationalising South Africas coal mines? These issues will be examined in this article. Introduction
South Africa is one of the worlds leading producers of coal. Its coal reserves are estimated at 3.8% of world reserves, making it the worlds eighth largest. It also has an extremely advanced level of technical and production expertise, and comprehensive research and development activities. In fact, it is acknowledged as a world leader of new technologies, such as a revolutionary process for converting low-grade superfine iron ore into high-quality iron units.

Despite this mineral wealth, South Africa has extremely high levels of poverty (nearly 60% of blacks live below the poverty line 1), unemployment (24.5% as of 2011) and income inequality (its Gini coefficient 2 is 6.3). Contribution to the domestic economy The following diagram indicates the mining and quarrying industries contribution to South Africas Gross Domestic Product (GDP).

GDP aBributable to Mining & Quarrying

240000 Rand in millions 220000 200000 180000 160000 140000 120000 100000 2005 2006 2007 2008 2009 2010

Contribu2on to GDP/ rand (m) 105991.6 132301.1 156969.7 201381 198180.1 223983.5
Source: Euromonitor International

Even excluding the quarrying sector, the mining industry contributes significantly to the countrys economy: as of 2011, it accounted for 9.3% of GDP and about a third of total exports. In addition, South Africa's mining industry provides vital support for the development and continued operations of numerous other domestic industries most notably, the energy, construction, water, engineering, as well as specialist seismic, geological and metallurgical services sectors. For example, 2 Copyright 2011 SMU Economics Intelligence Club

it accounts for 70% of primary energy consumption, 93% of electricity generation and 30% of petroleum liquid fuels. In 2009, the Chamber of Mines estimated that around R200-billion in value (about 8% of the 2009 GDP) was added to the local economy through the intermediate and final product industries that use minerals and resources produced by South Africa's mines. As such, the mining industry is critical to the South African economy as a whole. Present Situation: Coal is the largest category in the South African mining industry in terms of production, comprising nearly one-quarter of the industrys total production volume in 2011. Its coal mining industry is an oligopoly 3: Five multinational companies, Anglo-American, Xstrata, BHP Billiton, Sasol and Exxaro, account for about 80% of total coal production, while various small, privately-owned companies comprise the remaining 20%. Only the last two companies are based in South Africa. Anglo- American is based in London, Xstrata, in Switzerland, and BHP Billiton, in Australia. As such, much of mining revenue is channelled out of South Africa, exacerbating the problems of poverty and income inequality. The recently-enacted Mineral and Petroleum Resources Royalty Act attempts to remedy this by creating a royalties system to facilitate the distribution of benefits derived from mining activities. However, some consider it inadequate. The African National Congress Youth League (ANCYL) has been particularly vociferous on this issue, calling for the government to take over at least 60% of all mines without compensation. They argue that nationalisation of mines is the perfect solution to South Africas economic and social woes, as it would supposedly allow a more equitable distribution of income without compromising employment. But would nationalisation truly solve South Africas three key problems, poverty, inequality and unemployment? To answer this, let us first examine what exactly nationalisation involves, and the arguments for and against it. From there, we shall examine the possible economic effects, and then evaluate whether nationalisation would, indeed, be a feasible proposal for the South African mining industry. What Is Nationalisation? Nationalisation is the transfer of ownership of an industry or assets from a private entity to a national government or public body. It may be partial, with the government holding a majority stake, or total, which means that the public body has sole management and control. The arguments for nationalisation are numerous. Advocates of nationalisation argue, inter alia, that ownership under the state and the subsequent state regulation and oversight is the only way to ensure a constant minimum standard. Many also point out that with state control, steps to ensure the populations access can and will be affected even if it might not be cost effective to do so. This is because universal access and public interest is a key objective, instead of profits. Another oft-cited reason is that nationalisation can help to achieve a more equitable distribution of income, due to the wealth redistribution effect. Nationalisation causes income generated to move from private hands to the state, which then uses the income to fund projects aimed at improving citizen welfare and infrastructure. Wealth is thereby redistributed among the population, theoretically ensuring a more equitable income spread. 3 Copyright 2011 SMU Economics Intelligence Club

Some advocates also argue that nationalisation helps to achieve another key macroeconomic goal of full employment: since profit is no longer the sole goal, the business will be less inclined to cut back excessively on labour. Finally, the natural monopoly situation is another economic argument put forth in favour of nationalisation. Such industries produce essentially homogenous products, and experience large economies of scale due to size; thus, a monopoly would be more economically efficient than a competitive market structure. The above arguments are but some of many in favour of nationalisation. Persuasive though they are, the case against nationalisation is equally strong, and will be closely examined in Part Two of the article. Part Two also explains the possible domestic, regional and global impacts of nationalisation.

of data. South Africas is calculated based on the money income required to attain a basic minimal standard of living. 2 This is used to measure income inequality. The coefficient varies between 0, which reflects complete equality and 1, which indicates complete inequality. Situation in which a small group of companies dominate a particular market. Of only two are present, this is termed a duopoly. The dominant companies may collude to control supply or market price.
Sources: Euromonitor International, The Economist, Mining Weekly, The Chamber of Mines South Africa, Transparency International 2011.

There is no single definition of a poverty line. Countries construct their own by using various sets

4 Copyright 2011 SMU Economics Intelligence Club

Divided We Stand, United We Fall

By Adam Tan, Singapore Management University The terms Deutsche Mark, Spanish Peseta, Italian Lira and Greek Drachma seemed foreign to many of us from the younger generation. These currencies circulating in Germany, Spain, Italy and Greece respectively prior to the adoption of a common currency, the Euro, could resurface in the near future. The Euro Project with the objective of a single currency shared by the whole region, has been thrown into the limelight for most of this year and looks to be facing its greatest challenge since inauguration in 1999. The Spark Ever since this summer began, Greeces ability to restructure their growing (355 billion) international debt obligations remains largely in doubt and has been a point of scrutiny for the bigger players in the capital market. Unlike any other summers, Eurozone leaders have been feeling the heat from international bodies such as the European Central Bank (ECB) and the International Monetary Fund (IMF) to come up with a quick resolution to contain the crisis. Their main trade partners such as the United States, China and Japan have been relentless in voicing their concerns on the mainstream media to pile on more pressure. Frequent warnings by credit rating agencies such as Standard & Poors, Moodys Investor Services and Fitch Group on the possible downgrade of member states within the Eurozone on their sovereign credit ratings have added on more complications for the Eurozone leaders to resolve. The motto for teamwork and unity, United We Stand, Divided We Fall remains buried deeply in the minds of the European Union (EU) leaders during the recent high stakes EU summit at Brussels, Belgium. Even with such conviction to ameliorate the current predicament, little was accomplished much to the disappointment of the financial market participants. Whats next for Greece? A key issue on whether Greece should exit the Eurozone in a structured manner was clearly untouched during the 10-hour long meeting. Currently under the status quo European treaties, a member state which exits the Eurozone voluntarily will have to give up its membership in the broader EU, a scenario Germany is trying to avoid. However, every cloud has a silver lining, even for Greece to exit the Eurozone in the near future. Adhering to fiscal and monetary policies that will stifle growth in the long run is not a good sign. According to IMF forecasts, Greece will be finding it hard to cope with its austerity plan in place with GDP set to contract 6% in 2011 and 3% in 2012. Based on the data from IMF shown below, Greece governments net debt going forward will remain substantially high and is forecasted to be around 147% of GDP in 2016.

5 Copyright 2011 SMU Economics Intelligence Club

Net Debt to GDP Trend

190 185 180 175 170 165 160 155 150 145 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 GDP - LHS
Source: IMF World Economic Outlook

Billions ( Euros)

200% 180% 160% 140% 120% 100% Government Net Debt (% of GDP) - RHS

However, in reality, the scenario of Greece leaving the Eurozone may not be as grim as the taboo word default suggests and could even contribute to strengthening of the Eurozone in the long run, following an initial and inevitable period of volatility and turbulence. After defaulting and exiting the Eurozone, Greece may be able to reverse the negative growth and nationalise the banks to move towards more productive investments in the agriculture industry. Also, when reintroducing the Greek Drachma, the new currencys value would dramatically devalue against the euro, making the countrys exports competitive again. From the social aspect, the Greeks will also be spared of more painful jobs, salaries and pension cuts that affect the daily lives and livelihoods of the middle class. However, every well thought-out plan has its downsides. This plan may lead to higher national debts for Greece as their current obligations are denominated in euro despite taking a haircut1. Greeces current credit rating of CC2 (by Standard & Poors) could be further downgraded as Greek companies struggle to get access to money from the international capital market. Choosing the scenario above can probably lead to similar path experienced by Argentina in 1999 when it defaulted on its foreign debts and unpegged the Peso from the US dollars. Argentina eventually recovered to its pre-recession level of output in three years after the crisis and has been growing positively since. Greece can emulate the Argentinians and do what is socially and economically viable for its citizens. Next Patient Please So whats next for the EU leaders after Greece defaults? The EU leaders may certainly welcome this move as more funds from the current European Financial Stability Facility3 (EFSF), which set to be replaced by European Stability Mechanism4 (ESM) in July 2012, can be channelled to contain risks of high borrowing costs emanating from Italy and Spain. The recent bond auctions of Italy and Spain which set a new Euro-Era high of 7.3% and 6.975% yield respectively is a major cause of concern that needs to be address immediately. With Italy and Spain being the 4th and 6th largest economy in Europe, the worries of these 2 nations being too big to fail will be constantly on the minds of Chancellor Merkel and co after getting the Greece deal off the table. Similar to the Great Financial Crisis of 2008, a crisis that takes years to form cannot be completely resolved in a year (2011). The

6 Copyright 2011 SMU Economics Intelligence Club

EU leaders will have to stomach the volatility and turbulence ahead for the near future until a credible plan that inspires market confidence prevails.

Haircut: Reduction of value to debts or securities used as collateral in a loan

2 Standard & Poors definition of CC rating (Non-investment grade): An obligor rated CC is

currently highly vulnerable EFSF: Special purpose vehicle aim at preserving financial stability in Europe by providing financial assistance to Eurozone states in economics difficulty with a total guarantee up to 780billion 4 ESM: Permanent rescue funding programme starting in July 2012 with a total capacity of 500 billion 7 Copyright 2011 SMU Economics Intelligence Club

Sources: Bloomberg, IMF, The Wall Street Journal and Guardian

Are we creating another Tech-based Bubble?

By Gabriel Tan, Boston University The inspiration for this article came awhile back when Facebook was valued at over $50 billion. If this is hard to put into perspective, think about this: Microsoft is valued at about $215 billion, based on market cap (current share price multiplied by volume of shares). This values Facebook, a relatively young company whose only solid form of revenues is generic advertising, at about a quarter of the value of Microsoft, a company whose software is the dominant player throughout the world. Of course it must be understood that the market cap of a company (or an IPO valuation) is based primarily on the markets idea of the worth of an individual share of the company. While not yet at pre-crisis levels, it is clear from the number of US Tech IPO deals that recent market interest in this sector is rapidly increasing.
80 70 60 50 40 30 20 10 0 2003 2004 2005 2006 2007 2008 2009 2010 No. of IPO Deals in US Tech Sector

Source: Renaissance Capital Ideally, a shares price is valued by finding the present value of all cash flows that the share will generate a combination of dividend returns and capital gains. These cash flows are based on company profits (dividends are a percent of profits) and revenues, which broadly identify a companys growth potential. In the case of Microsofts 2011 fiscal year, we see revenue of just shy of $70 billion and a net profit of about $23 billion. However, Facebooks estimated revenue from advertising, their sole source of income, was estimated to be about $2 billion. From this we learn that Microsofts revenue is about 35 times greater than Facebooks and yet is only valued at 4 times of Facebook. The argument that would normally be presented for any other company would be that the high current valuation is based on the speculation that the company will grow and in turn revenues and profits will grow in line with the current valuation. Without using financial modelling such as a DCF model, I am confident that there is no way that this social medial site can increase its revenues to come even close to its current valuation. The reason is simple: lack of revenue drivers. In an industry where the customer pays for virtually nothing, market share means little. Although the social media giants like Facebook and LinkedIn can highlight impressive numbers of users, they simply cannot do the same with their revenue and profit numbers. Besides generic online advertising, which is proving to be less effective than once thought, what other revenue drivers do these sites have? The question that then beckons to be asked is what is causing these over-inflated prices of social media sites? The reasons behind many bubbles are 8 Copyright 2011 SMU Economics Intelligence Club

varied. In this case, I believe that investors are overly confident about the true capability of social media sites to generate cash flows and this overconfidence is what is causing the disparity between valuation and intrinsic value. Of course it is virtually impossible to judge the true intrinsic value of companies like Facebook that are both young and enigmatic when it comes to their financial performance. Hence, only time will tell whether not there is truly a disparity. For the sake of this article being holistic, we should consider the situation in which social media sites are not being overvalued, meaning that future cash flows generated would in fact be in line with the high valuations. This could be achieved by generating new forms of revenue. New forms of advertising or user based donations and subscriptions may cause spikes in revenues and profits. However, it is still my opinion that these options are too limited to justify the current markets view of social media. It may seem that this article has been very narrowly focused on Facebook and perhaps the financial basis of stock valuation. Although this is true, it is important to realize that Facebook is simply the poster boy of the social media and online trend, other businesses that are piggy backing this social media wave exhibit similar trends in valuation. From an economic perspective, if this is indeed a bubble, it must pop at some point. When this happens, equity prices will plummet, investor confidence will drop and a loss in wealth will occur. Although the degree to which a bubble affects the economy is debated, it is generally accepted that it is not a good thing. In economic times as turbulent as these, the last thing investors need now is another blow to their confidence and the potential to lose accumulated wealth overnight. The important lesson that history has taught us is not to get caught up in investor hype and to never purchase an asset simply because of rising prices. Sources: The Economist, Yahoo! Finance, MSNBC 9 Copyright 2011 SMU Economics Intelligence Club

In the next issue of SPEX

What are the Economic Implications of Nationalization? (Part 2) & much more

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 Shane Ai Changxun changxun.ai.2010@smu.edu.sg Singapore Management University Singapore Tan Jia Ming Jiaming.tan.2010@smu.edu.sg Singapore Management University Singapore Adam Tan Adam.tan.2009@business.smu.edu.sg Singapore Management University Singapore Kwan Yu Wen (Designer) Ywkwan.2010@economics.smu.edu.sg Singapore Management University Singapore

Ben Lim ben.lim.2010@smu.edu.sg Singapore Management University Singapore Lisa Ho lisa.ho.2010@law.smu.edu.sg Singapore Management University Singapore Gabriel Tan gtan@bu.edu Boston University United States Herman Cheong (Designer) wq.cheong.2011@economics.smu.edu.sg Singapore Management University Singapore

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