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Global Pandemic Fallout Asia/Pacific EM Bubble May Burst in 2006 View GEF Archive

The World Health Organization (WHO) currently reports 170 confirmed human cases of avian flu worldwide with 92 deaths — a staggering mortality rate in excess of 50%.  Sustained transmission among humans, however, has not yet been documented.  Given sufficient opportunities to mutate and adapt, H5N1 may evolve into a fully contagious virus capable of triggering a pandemic.  If it does, there will be limited opportunity to react — past influenza pandemics have spread globally within six to nine months.

Considerable uncertainty surrounds the timing and virulence of such an event.  Over the past 300 years, the world has experienced ten influenza pandemics.  The Black Death (1347-50) and Spanish Flu (1918-19) had, by far, the most profound global impacts, killing an estimated 60-70 million people combined.  Europe lost an estimated one-third of its population to the bubonic plague, and more than 1% of the world population perished during the 1918 outbreak.  In contrast, the pandemics of 1957-58 and 1968-69 were far less severe, with a death toll of three million people.  In 1976, the death of an American soldier due to swine flu, coupled with fears that a devastating pandemic was overdue, led to a national vaccination campaign in the US.  Fortunately, the disease did not appear, but in its haste to encourage and expedite vaccine production, the US government exposed itself to over $3 billion in liability costs.

Economies highly dependent on external trade such as the US and East Asia, along with their trading partners and industries accustomed to lean inventories and just-in-time delivery, would be particularly hard hit.  Over the past decade, the prevalence of infectious disease-related trade disruptions has escalated.  Imports now account for as much as 75% of the produce stocked at many US grocery stores, and in 1996, raspberries from Guatemala were blamed for outbreaks of cyclospora, a protozoan parasite.  Recent outbreaks affecting pork, beef and poultry have raised similar health safety concerns.  According to the UN Food and Agriculture Organization (FAO), animal diseases currently affect one-third of all meat exports in the form of sanctions, bans or other risk-based regulatory measures.  In 1995-96, mad cow disease cost the British beef industry $5.8 billion in lost exports and reduced consumption.  Subsequent outbreaks in Japan (2000), Canada (2003) and the US (2004) amounted to an additional $6 billion in lost revenue.  In 2001, the UK was besieged with the onset of foot and mouth disease (FMD), which ultimately cost its pork industry $9.2 billion.  Several years earlier, FMD brought Taiwan’s pork industry to a halt, exacting nearly $7 billion in direct losses.  Outbreaks of classical swine fever in the Netherlands (1997-98), nipah in Malaysia (1999), and recent confirmation of FMD in Brazil have been equally devastating.

Since the first clinically diagnosed case of H5N1 human infection in 1997, avian flu has spread from Hong Kong to seven other countries, causing roughly $10-15 billion in damages to the Asian poultry industry.  Economic losses have also affected upstream producers such as feed mills and breeding farms as well as downstream sectors like poultry traders.  In the past two years alone, 150 million birds have either died or been slaughtered through mass culling efforts.   This number is set to increase as 13 additional countries on three continents have reported new outbreaks in birds during the month of February, with India just last week.  While the poultry industry’s value-added to Southeast Asia’s regional economy amounts to just over 1% of GDP, the costs associated with containing avian flu has fallen disproportionately upon “backyard” producers.  In some countries, these small farmers and peasants account for a majority of the poultry production (e.g., 60% in China), raising their animals on small plots of land surrounding their homes.  In Vietnam, for example, the poorest quintile of households is three times more reliant on poultry income than the highest quintile.  Unless the government can provide adequate financial compensation to offset the loss in livestock, farmers have little incentive to report illnesses amongst their flock.  Given that a country like China has an estimated 13 billion chickens and over 500 million pigs spread over large rural areas, this informal channel of surveillance is critical to reducing the spread of the disease and its transmission amongst commingled animals.  Over time, this cross-contamination can lead to mutation of the H5N1 virus into a form that is more easily transmittable to humans, and then among humans.

Globalization and cross-border connectivity significantly alters the transmission mechanism of the next pandemic relative to those of the past.  The recent SARS outbreak provides only a hint of the potential fallout.  In early 2003, the disease spread from rural China to five countries within a matter of days, and by summer, SARS was documented in 30 countries across six continents.  Although contagion was limited, infecting about 8,000 people with 10% mortality, the fear and uncertainty it generated led to swift quarantines and the lockdown of national borders.  The financial implications were considerable as entire industries came to a virtual standstill.  For a region that derives 11% of its GDP from tourism, the cancellation of nearly half of all international flights to Southeast Asia and 70% of flights between Hong Kong and the US was devastating.  Industries such as semiconductors, which rely heavily on the freight service provided by these planes, were similarly affected.  Repercussions extended to Australia as well, which saw tourist arrivals fall by 20% even though it had only one confirmed case (which happened to be a German tourist in transit).  All told, the economic impact of the six-month SARS epidemic amounted to some $40 billion for the Asia-Pacific region.

Quantifying the economic impact of the next pandemic, be it avian flu or otherwise, is next to impossible.  Data based on past outbreaks and assumptions on both virulence and mortality rates are helpful in framing the debate, but can yield markedly different results.  The Asian Development Bank (ADB) models two Asia-specific scenarios based on a mild pandemic: (1) “short-lived shock” leads to losses equal to 2.6% of regional GDP, and (2) “prolonged shock” leads to losses of 6.8%.  In a report issued this past November, the US Department of Health and Human Services predicts that a moderate outbreak in the US would lead to $180 billion in medical costs alone.  Total economic damages, however, would be far greater than these conservative estimates due to the second-round effects that disrupt manufacturing and supply chains, halt travel and transportation, and lead to shortages in both critical (e.g., medical equipment, vaccines, potable water) and non-critical (e.g., autos, electronics, clothing) goods.  If we assume that the economic loss from the SARS epidemic amounted to 2% of East Asian GDP, and use ADB’s “prolonged shock” scenario as an upper bound, a ballpark estimate for the global economy would put the impact from a pandemic in a range of $880 billion to $3 trillion.

As noted above, the world population is highly susceptible to an H5N1 pandemic, mainly because the human immune system has no pre-existing or residual immunity to the underlying virus.  Although prevention is the most cost-effective measure, limited production capacity and high costs make universal vaccination difficult.  The global supply of flu vaccines has never exceeded 300 million doses a year, which is barely enough to vaccinate the US population, let alone the world’s 6.5 billion people.  Two antiviral drugs are currently on the market (Roche’s Tamiflu and GlaxoSmithKline’s Relenza), but it would take roughly a decade to manufacture enough to treat even a fifth of the world’s population.  All told, the laborious manufacturing process and limited shelf life, coupled with liability concerns, has led to massive consolidation within the industry.  From two dozen companies in 1980 to just a fraction of that today, vaccines now account for about 1.6% of the $400 billion global pharmaceuticals market.

No one knows whether H5N1 will lead to the next pandemic, but just the slightest chance of an outbreak implies that we need to take these risks seriously in assessing prospects for the global economy and world financial markets.  While doomsday scenarios and calls for massive mobilization are likely to be counterproductive, media coverage has stirred governments and their people out of complacency.  It is crucial to seize this moment by strengthening research on infectious diseases, and better integrating national strategies on biosecurity standards and surveillance.  Reducing opportunities for a pandemic virus to emerge is far more cost-efficient than containing its spread.  This will require the active and coordinated participation of households, businesses and governments, with an explicit recognition that any successful solution must be framed within a global context.

Asia/Pacific
EM Bubble May Burst in 2006
Feb 28, 2006

Andy Xie (from Shanghai)

Summary & Conclusions

Declining risk premium has been driving the emerging market (EM) boom.  The EM sovereign risk premium has declined from an average of 352 bps in 1H04 to 52 bps.  MXEF has risen by 82% since mid-2004.  In 2006, the EM sovereign spread has declined from 76 bps to 52 bps and the MXEF index has risen by 11%.  As the EM risk premium gets close to zero, the base effect suggests that the EM ‘re-rating’ story is also coming to an end.

Recent social, security, and economic risk events suggest that the decline in EM risk premium cannot be justified by fundamentals.  Liquidity and momentum explain most of the decline in EM risk premium, I believe, with much of the gain in EMXF due to overshooting.

As the EM boom stalls due to a high base, events have greater potential to trigger the risk reduction trade than before.  The reverse momentum could have the same power as the forward momentum.  I believe the EM boom overshooting could reverse and then some in 2006.

The Incredible Shrinking Risk Premium …

The rapidly declining risk premium of EM debt rivals the flattening yield curve as a conundrum for financial markets today.  The EM sovereign risk premium averaged 352 bps in 1H04, when the perceived risk was not high.  It has since declined to 52 bps.

Substantial improvements in EM fundamentals have accompanied the risk premium decline.  Brazil and Russian have been taking advantage of their good fortune from high commodity prices to pay down foreign debts.  Korea has become a developed economy by most measurements.  The three economies that were embroiled in financial crises in 1998 have fundamentally changed their balance sheets.

Further, most emerging economies have been running trade surpluses during the current boom, unlike in previous booms.  The surging US trade deficit is the main factor enabling emerging economies to enjoy trade surpluses.  The liquidity boom that may have caused the flat yield curve and strong consumption in the US has allowed EM economies to improve their fundamentals.  Hence, the improving EM fundamentals would appear part of the bubble, rather than suggestive of a change in secular trend.

However, the fundamentals do not explain all the decline in the risk premium.  The trend of improving fundamentals in Brazil, Russia, and Korea was well established in 1H04.  Many small EM economies without similar improvements in fundamentals have enjoyed a similar decline in risk premium.  The ‘liquidity effect’ may be a bigger factor in explaining the declining risk premium than improving fundamentals.  Momentum-investors piling into a winning trend without improved liquidity may explain the entire decline in risk premium in recent months, I believe.

… and the Meteoric Rise of EM Equity …

EM equity has enjoyed a meteoric rise as the sovereign risk premium has declined, with the MSCI Emerging Market Index (EXMF) rising by over 80% since mid-2004.   The same force – the global liquidity boom – drives both.  There is no fundamental causality between the two.  As equity investors tend to use bond risk premiums in calculating equity values, the declining sovereign bond risk premium technically causes a rising EM equity market.  MXFM has appreciated by 11% so far in 2006, while the EM sovereign risk premium has declined to 52 bps from 76 bps. 

I estimate the declining risk premium may explain 90% of the appreciation in EM equity since mid-2004.  However, momentum has now emerged as a more important factor.  The change in the risk premium may explain less than half of the EM equity rise in 2006, I believe.  As the EM sovereign risk premium becomes too low to fall, momentum becomes the main factor explaining EM equity movement.

… but There Are Risk Events Aplenty …

Events in recent days suggest that the low EM risk premium may not be justified.  The terrorist attack on an oil facility at Abqaiq, the imposition of a state of emergency in the Philippines, Mr. Thaksin’s dissolution of the Thai parliament and call for an early election, and the abolition of the Unification Council in Taiwan are events that can change the economic trajectory for a regional or global economy.

EM risk premium exists not just because of the external balance situation.  The lack of institutions that enhance future visibility is far more important.  It seems to me absurd to believe that such economies can enjoy just 50 bps of risk premium.

Economic risks are rising also.  India, Thailand, and the US may be behind the curve in tackling their inflation problem.  This could lead to worsening trade balances for these economies.

The policy of the Bank of Japan is perhaps the biggest area of uncertainty as regards the EM boom.  The BoJ is probably the lender of last resort in the global financial system.  The massive carry trade – borrowing yen to borrow US treasuries for interest spread income – may be the explanation for the flat yield curve.  Indirectly, I believe the BoJ liquidity may have caused the collapse in the EM risk premium.

… and the Risk Premium Cannot Drop Below Zero

While momentum is still strong in favor of high beta assets, the near zero risk premium on EM sovereign debt suggests that the boom is nearing its end.   The base effect is about to boomerang on EM assets, I believe.  Simply put, the risk premium cannot drop below zero.  If the EM sovereign risk premium drops to zero, the implied increase in EM equity value is another 12% at most, on my estimates. 

The high base effect suggests to me that the momentum in the EM market could hit a wall this year.  We could see repeated surges and retreats in the coming weeks.  However, maths is against forward momentum.  When markets fail to reach new highs a few times, momentum tends to shift the other way.  Then, it may take just one event to trigger reverse momentum – that is, the risk reduction trade.

India’s Sensex, China’s H-share index, and Japan’s TOPIX are where risk-takers have been congregating.   I believe comparing them against the NASDAQ in 2000 yields potentially useful indications of when these markets might run out of steam and reverse.

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