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fore sight A Magazine for Euler Hermes ACI Customers Volume 6, Issue 2 Fall 2008 The Outlook for Global Industry Sectors Also inside: Zoom in Latin America Country Spotlight: China SPOTLIGHT

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Page 1: Foresight Magazine

foresightA Magazine for Euler Hermes ACI Customers

Volume 6, Issue 2Fall 2008The Outlook for Global

Industry SectorsAlso inside:Zoom in Latin America Country Spotlight: China

Spotlight

Page 2: Foresight Magazine

It is evident that our economy is currently in crisis. The U.S. financial markets are facing serious peril which, in turn, has caused widespread calamity across the global financial system. The forecast for the economy is negative and liquidity continues to be scarce, presenting major challenges within the business landscape.

The federal government is taking steps to calm economic fears and right the financial system, but it will take some time for these measures take effect. In the meantime, the credit crisis is spreading into the broader economy, making it more difficult for businesses to meet their financial obligations.

Simply put, we are in a recession the likes of which this country has not seen in two decades. At times like these, we all need to exercise caution as we navigate through the rough seas of the current economic environment.

It is my sincere hope that the information contained in this issue of Foresight helps you as we navigate through these challenging economic times.

Regards,

Paul OvereemPresident and CEOEuler Hermes ACI

Send comments and suggestions to [email protected].

By necessity, a time for calm and caution

Contentspage 2 | The OuTlOOk fOr glObal

IndusTry secTOrs By Karine Berger

page 4 | ZOOm In laTIn amerIca

By Arjan van de Wall

page 6 | 2008: The year Of lIvIng dangerOusly

By Dan North and Karine Berger

Country Spotlight: China | Page 1 By David Atkinson

Page 3: Foresight Magazine

cOunTry spOTlIghT: chInaBy David Atkinson, Euler Hermes Country Risk Manager

China’s economy continued growing at a frenetic pace in 2007. Government measures to rebalance the economy, in particular its monetary tightening

via interest rates and reserve requirements, failed to brake either productive investment, foreign trade, or the growth in private consumption.

GDP growth exceeded 10% for the fifth consecutive year at 11.9% after upward revisions. Chinese growth thus accounted for a fourth of world growth in 2007 and helped the country post the world’s second-biggest trade surplus ($261 billion) after Germany, as well as foreign exchange reserves of $2 trillion. These exceptional performances were accompanied by an improvement in the business climate without, however, constituting guarantees of profitability, solvency, or businesses making payments on time. At a time when banks’ bad debts appear to have risen to nearly 1.8 trillion yuan, nearly 4,400 businesses were declared bankrupt over the year. That’s a small figure given the size of the Chinese economy, but it nonetheless represents a more-than-expected 20% increase, with China’s new insolvency legislation, widened to cover all legal business forms, having come into force only in June.

2008–09 insolvency outlook: further increases China should see its growth drop to below 10% a year from 2008. Its economy has not yet reached the critical mass that would make it immune to a slowdown in foreign trade, in particular with the United States. Other braking factors also should play a role, such as the appreciation in the yuan, imported commodity prices, and the increase in food prices. But the authorities, looking for balanced growth and concerned about political and social stability, will not take the risk of a more marked braking, and they have already taken measures to stimulate activity. Still, business insolvencies should continue to rise, with the increasing understanding and use of the new insolvency regulations, and with the development of the commercial law framework (e.g., the competition legislation effect from mid-2008). We expect the number of business insolvencies to increase by 10% on annual average, the rate observed over the first four months of 2008.

monetary policy: inflation concernInflation fell to 7.1% year-to-year in June (8.5% April peak) as food prices began to ease. Yet with non-food inflation resuming its shallow uptrend (1.9% in June) and producer price increases at 8.8% year-to-year, authorities can ill afford to let up on monetary tightening, though

the removal of fuel price subsidies points to a degree of confidence that headline inflation has peaked.

Monetary policy was tightened further in the second quarter with an unexpectedly large increase in bank reserve requirements and a resumption of exchange rate

By necessity, a time for calm and caution

China should see its growth drop to below 10% a year from 2008. Its economy has not yet reached the critical mass that would make it immune to a slowdown in foreign trade, in particular with the United States.

continued on page 8

Page 4: Foresight Magazine

2

t he world economy started 2008 in a financial storm. The subprime crisis, resulting

from the collapse of the real estate bubble in the United States and from securitization methods, has spread to the heart of the financial markets. With the steady stream of announcements of write-downs in bank assets by several billion dollars — losses potentially engendering systemic risk — the pressures on the financial markets have continued to mount. Falling share prices and increased volatility are simply the downside of a sudden lack of liquidity.

Volatility was thought to have peaked around mid-March, suggesting that the worst of the financial crisis, strictly speaking, may have passed or, in any event, that Act I was over. In this environment, the performance of real economies in the first half of 2008 came

as a surprise, with every country posting better growth than expected while, against all expectations, activity in Organisation for Economic Co-operation and Development countries accelerated as well.

At same time, expectations of those who constitute the economy — producers and consumers — were down on both sides of the Atlantic. Businesses knew they were about to enter a clearly more difficult stage of the cycle, facing both increasingly hard financing conditions and a slowdown in demand. This is because the shock waves spread, to a greater extent than anticipated, to the entire business and household financial markets. The spread of the crisis to the real economy via the restriction of credit is only the beginning. Why? Because to compensate for their refinancing costs, the banks could either increase interest rates for corporate lending or decrease lending amounts. Or both.

When a credit crunch begins in a given market — in this case, construction — economic history teaches us that it often blindly spreads to other markets. Logically, because of the overvalued state of property markets

in the United States, Spain, and to a lesser extent the United Kingdom, their construction markets are the first to be hit. Less logically, credit conditions for other productive sectors also harden to a degree. The Bank of France’s survey of credit distribution shows that banks are planning not only to continue raising their margins, but also to reduce the amount and the duration of loans to both large companies and small businesses. As to restrictions on credit to individuals, these are especially noticeable in the United States; Europe, for its part, still seems little affected. Even so, consumers are in a state of readiness and, in the euro zone, consumption slowed in the first quarter.

The stage is set as we continue to wade through Act II of the financial crisis of 2008.

While the sun is still shining over Asia and Latin America, our world sector outlook has considerably darkened in the space of a few months. The paradox is that the productive sectors in the real economy fundamentally have nothing much to do with the creation of ill-controlled financial derivatives in the financial markets or with the unreasonably high housing prices in the United States. Yet it is the productive sectors — and particularly average-sized U.S. and European businesses — that undoubtedly will feel the brunt of this in 2008 and 2009.

construction: sparking and prolonging the crisis The real economic crisis has already taken hold in the construction sectors of

the outlook for global industry Sectors

acT I Of The

fInancIal crIsIs was

mIld. nOw we wade

ThrOugh acT II

By Karine Berger, Euler Hermes Director of Economic Research

Businesses knew they were about to enter a clearly more difficult stage of the cycle, facing both increasingly hard financing conditions and a slowdown in demand.

Page 5: Foresight Magazine

several countries. We think this will continue into 2009. Because of the past overvaluation in real estate prices, households in the United States, Spain, and the United Kingdom suddenly had to reduce their debt, unable to make payments on loans that exceeded the price of the goods bought. At the same

time, financial-institution lending was drawing to a halt.

Household investment thus fell by 25% in a year in the United States. Despite slightly less negative news on construction starts in April, the situation is unlikely to improve before next year. A fairly similar bursting of

the bubble led to the same result in Spain, and the difficulties are only beginning to affect construction in the rest of the euro zone. The notable exception is Germany, where the classic rule of positive climate effects on construction could be seen.

the american consumer has run out of Breath…American consumption, once thought to be the unstoppable engine behind a large part of the world economy and trade, has been temporarily stopped by the de-gearing responses imposed by the financial crisis. No one else in the world is really capable of stepping into the breach. Even with the impressive growth in domestic demand in the BRICs (Brazil, Russia, India, and China), the volumes concerned are not yet comparable. In automatic fashion, the clouds are gathering over two productive sectors sustained up to now by the force of U.S. demand.

The first of these is the automotive sector, where there is a growing gap between the sector in the Organisation for Economic Co-operation and Development countries and their counterparts in the BRICs, growing fast and positioned in low-cost products. The hesitant state of the automobile industry overall has repercussions in the automotive components sector, in distress for even longer.

The second sector in which the effects of the braking in American demand is starting to be noticeable is distribution. This sector, already forced to implement strategic repositioning, in particular to avoid betting all on distributors’ domestic markets, also must face slowing consumption, rising food prices, and a war on margins. By contrast, two other suppliers of consumer goods — the consumer electronics and pharmaceutical sectors — seem less affected by a slowing in demand, although this has come at the price

3

Industry Spotlight

American consumption, once thought to be the unstoppable engine behind a large part of the world economy and trade, has been temporarily stopped by the de-gearing responses imposed by the financial crisis. No one else in the world is really capable of stepping into the breach.

continued on page 8

Page 6: Foresight Magazine

4

Zoom in latin America

atin America is one of the fastest-growing regions in the world (after China and India). Thanks to free-trade agreements such as NAFTA and CAFTA, the region provides a great source of potential new buyers for U.S. goods and services. North-to-south trade volumes from the United States to Latin America have grown steadily over the past few years. Additionally, trade flow out of Latin America to the rest of the world has been increasing.

economic/insolvency outlookInflationary pressure has been met with higher interest rates in much of the region — including Brazil and Mexico — as central banks have moved swiftly

grOwTh wIll slOw,

buT expecT The

regIOn TO maInTaIn

ITs resIlIence

By Arjan van de Wall, Euler Hermes ACI Senior VP — Director of International Development, Marketing & Strategy

l

Page 7: Foresight Magazine

5

Feature Article

to damp expectations, underscoring improvements in the policymaking framework that argue well for the region’s resilience to financial crisis. Nonetheless, growth will slow noticeably through 2008–09. As commodity exporters, many economies’ external balances remain supported, but a reversal of recent trends could pose problems.

There are exceptions to the positive response to accelerating inflation, principally in the economies with radical left leadership, where there is little to suggest that inflation is being dealt with effectively. In most cases, though, high energy prices continue to provide a cushion. Central American and Caribbean economies that are highly dependent on tourism and remittances from the United States remain in the forefront of the regional slowdown.

Overall, the Latin American region should prove more resilient than it did during previous slowdowns in the United States, but the weakening of world demand and the hardening of financial conditions will act to slow growth below expected targets in 2008 and 2009. The negative growth impulse from foreign trade will increase in 2008 and 2009, with the easing in exports and sustained growth in imports. Household demand and business investment are likely to remain sustained. The trend seen over the initial months of 2008 in business insolvency remains downward and suggests that the number of cases will fall further in 2008 and 2009.

Euler Hermes’ growth in Latin America has mirrored the increasing importance of the region — the combination of ambition and hard work has put us on the map in the credit insurance market. Our Latin American subsidiaries in Mexico (in operation since 2003) and Brazil (in operation since 2004) have experienced significant growth in the past few years. Our newest subsidiaries, Euler Hermes Argentina and Euler Hermes Colombia, opened

in December 2006 and February 2008, respectively. These offices are operated in close cooperation with our ultimate parent company, Allianz, one of the world’s largest insurance companies.

Here is a look at each of our business units in Latin America:

euler hermes mexico• 33 employees • Regional sales presence in

Monterrey, Guadalajara, and Querétaro

• Full-scale operation with risk, commercial (underwriting, sales, and telemarketing), finance, claims, and in-house collections

• Whole turnover, key account, single-buyer policies offered

• Target industries: food, plastics, chemicals, machinery, apparel, pharmaceuticals, high-tech

• Target market: Medium and large companies, domestic and export markets. Political risk also offered.

euler hermes Brazil• 25 employees • Regional presence in Porto Alegre• Main office in Sao Paulo

(financial district)• Full-scale operation with risk,

commercial (underwriting, sales, and telemarketing), finance, and claims

• Whole turnover, key account, single-buyer policies offered

• Target industries: food, electronics, chemicals, automotive, apparel, pharmaceutical, steel

• Target market: Medium and large companies on domestic and export market. Political risk also offered.

euler hermes argentina• Seven employees• Policies fronted by Allianz• Based in Allianz building• Full-scale operation with risk,

commercial (underwriting, sales, and telemarketing), finance, and claims

• Whole turnover, key account, single-buyer policies offered

• Target industries: food, consumer electronics, chemicals, automotive, apparel, high-tech

• Target market: Medium and large companies on domestic and export market. Political risk also offered.

euler hermes colomBia• Office launched in February 2008 • Policies fronted by Colseguros

(Allianz), second-largest insurance company in Colombia

• Four employees, based at Allianz• Commercial (sales), account

management, and risk presence• Whole turnover, key account,

single-buyer policies offered • Target industries: electronics,

chemicals, plastics, auto parts, apparel, food, tiles, cement, flowers

• Target market: Medium and large companies on domestic and export markets.

Euler Hermes’ presence in Latin America is strong, and our plan is to continue growing in the region with new sales offices in existing markets and new subsidiaries in new markets. We will offer the same optimism and ambition that have allowed us to become one of the major players in this very competitive marketplace.

The demand for credit insurance in Latin America continues to grow strongly, as Latin America continues to be one of the fastest-growing regions in the world. Main growth is driven by large multinational companies that recognize the need for global programs with local service.

Middle-market companies are rapidly increasing interest in this product as well. Euler Hermes has made substantial investments in the region and is now located in all major Latin American markets. We look forward to continuing and expanding our relationship with businesses in the region and companies in the United States that are looking for a southerly flow of trade. r

Page 8: Foresight Magazine

6

W ith the end of summer 2008, storms battered world stock markets like the hurricanes

lashing the coasts of America. After the U.S. Treasury rescue of Fannie Mae and Freddie Mac, and especially after the grant of Chapter 11 protection to 160-year-old investment bank Lehman Brothers, all the facts that seemed to slightly ease concerns over the summer are now forgotten, and 2008 is now well and truly the year of living dangerously on the financial and economic fronts.

Admittedly, commodity prices — in particular, oil prices — have started to ease but, for the moment, they may continue to fluctuate around levels never seen before 2008. Also admittedly, the U.S. situation has seemed more favorable, with growth of 1% in the second quarter of the year. However, this upturn is explained in very large part by gains in export price competitiveness related to the fall in

the dollar against all other currencies. Over the whole of 2008, more than three-quarters of U.S. growth will come from the contribution of foreign trade, and it will be impossible for the world’s leading economy to repeat this performance next year.

At the same time, the spreads applied on lending to businesses (that is, the premium over government bond rates that large companies must pay to raise finance on the markets) have not stopped increasing, demonstrating the genuine blockage in investment finance, affecting even very large global businesses. And at the beginning of September, the bankruptcies by financial institutions in the United States and major world industrial or services companies showed that the worst is yet to come. The euro zone outlook is now a cause of increased concern following its results for the second quarter, during which

2008: the Year of living Dangerously

The u.s. and glObal

ecOnOmIes are

weaTherIng severe

sTOrms, buT

clearer skIes are

On The hOrIZOn

By Dan North, Euler Hermes ACI Chief Economist, and Karine Berger, Euler Hermes Director of Research

World Economic groWth, AnnuAl AvErAgE in %

Source: Euler Hermes Research Department and DataStream. 2008

5

4

3

2

1

098 99 00 01 02 03 04 05 06 07 08 09

OECD countries

No recoverybefore 2009

Rest of world

Page 9: Foresight Magazine

7

Economic Outlook

overall domestic demand in the zone contracted. The European economies have thus moved in tune with the U.S. crisis since spring, and the preliminary figures for the summer suggest that this situation is not improving. However, improvement is indeed in the forecast for 2009.

financial tsunami on an already depressed domestic marketThe U.S. economy overall proved more resilient than expected to the triple shocks it underwent in the first half of 2008: • Soaring inflation (rising to more

than 5% in July), stoked by the rise in energy prices and further worsened by the weakening in the dollar.

• The deterioration in financing conditions in the wake of the banking and financial crisis, affecting households and businesses.

• The reversal in the wealth effect, in parallel with the fall in real estate and stock market prices.

But the bulk of this first-half performance came from two factors that fueled the second quarter (up 0.8% over the previous quarter despite significant destocking). One of these was the fiscal package announced at the start of year, whose implementation from May made it possible to redistribute more than $100 billion to 100 million American households, even if part of this went into savings. The second, and more notable, was continued export growth, driven by the dollar’s further weakening to a new low (after dropping by 4% from the previous quarter and by 16% over a year), thus the expectation that foreign trade will account for three-quarters of U.S. growth for the year.

We expect to see insolvencies continue to rise into 2009. Business bankruptcies (including liquidations) have risen 40% in the past four quarters compared with the previous four. Business conditions have been difficult for several quarters, resulting in cumulative operating losses that are pushing an increasing number of companies toward bankruptcy. One leading indicator of future business bankruptcies is the Federal Reserve’s

quarterly survey of bank lending officers. The most recent survey showed a record-high percentage of bankers widening spreads and tightening lending conditions on commercial and industrial loans, a likely harbinger of increasing bankruptcies.

Current economic conditions are decidedly negative and we expect them to remain so into 2009. Both retail sales and wages are shrinking on a real year-over-year basis, home foreclosures and delinquencies are at record highs, housing prices continue to plummet, and job losses and unemployment are

on the rise. Unfortunately, several of the forces that caused the United States to go into this slowdown are still in place — high energy prices, an imploding housing market, and tight credit conditions — so we expect the business environment to remain negative for several quarters.

On the positive side, housing affordability is skyrocketing, and house prices may have reached a fair value. In addition, the Fed’s aggressive loosening of monetary policy in 2007 and 2008 is quite likely to lift the economy out of this downturn in 2009. r

The U.S. economy overall proved more resilient than expected to the shocks it underwent in the first half of 2008.

Page 10: Foresight Magazine

8

continued from Country Spotlight, page 1

Growth of non-processing imports is more pronounced than that of processing imports, which indicates that, while the external sector is feeling the chill from the global slowdown, domestic demand remains relatively robust.

continued from Industry Sectors, page 3

appreciation. A key problem in the first part of 2008 was monetary easing in the United States, which increased capital inflows and foreign exchange reserves, adding to monetary pressures in the absence of adequate exchange rate appreciation. This suggests that authorities will maintain the more rapid pace of currency appreciation. Nonetheless, they will remain relatively cautious overall, not least because of the potential for slowing global demand to hit growth by more than would be desirable.

external sector: exports slowingAccording to World Bank estimates, export growth in volume terms in the first five months of 2008 eased to 12% from 18% a year earlier. Import growth by volume also softened, though the overall trend is a drop in the net export contribution. Nominal export growth to the EU, a strongly supportive driver, has begun to slow. With nominal import growth on a sharply rising trend, boosted by higher energy costs, the current account surplus should ease to 9.4% of GDP this year and 8% in 2009. Growth of non-processing imports is more pronounced than that of processing imports, which indicates that, while the external sector is feeling the chill from the global slowdown, domestic demand

remains relatively robust. Foreign exchange reserves have continued to rise rapidly, maintaining pressure on monetary policy.

household demand: roBust sales Retail sales in the first six months of 2008 were up 21.4% year-to-year (23% in June alone) and, even after adjusting for higher inflation, sales remain robust. Real income growth appears to be the main driver, helped by a pickup in rural incomes. This should sustain private consumption through 2008 and 2009, though consumer confidence indicators are less robust than earlier in the year. The fall in asset prices will have limited impact.

Business: slowing trend emerging Fixed asset investment growth was 26.3% in the first half of 2008, broadly in line with the average of 2007. However, after allowing for accelerating investment goods prices, a slowing trend is emerging. Moreover, corporate profits growth, though still just above 20%, has entered a downtrend and, with rising input costs and wages, profits growth may ease further in the second half of 2008. The latest business climate index also indicates a modest downturn in confidence. r

of a drastic squeeze on their margins. In other words, volumes are holding up without really guaranteeing companies’ profitability.

…But Businesses continue to investThe warning signals heard in practically every sector dependent on consumption have not yet registered in those reliant on investment. Thus, some sectors were still faring well in 2008: the capital goods sector and intermediate products (steel and chemicals). Their good performance results mainly from emerging Asian capital goods’ demand for productive investment, arising from their continued increase in production capacities. As long as the profitability of these goods does not weaken, this should continue. On these markets, the exchange rate picture gives a clear competitive advantage to the United States over the euro zone in exploiting the rise in these markets.

However, for this year and next, we see at least three factors that may come to moderate the current good state of investment: initially, the gradual adaptation of supply to slowing demand; then, the reduc-tion in lending to businesses; and third, and above all, the upsurge in commodity prices. At this point, the flight in commodity prices is not just creating losers: The big winner in the current situation is the energy sector — as long as the slowdown in demand does not at some point wipe out the benefits accrued as prices have risen. But a number of sectors are faring far less well in the face of worsened profitability: road transport in Europe, and the food and beverage sector worldwide. r

Page 11: Foresight Magazine

euler hermes acI In The news

Nationwide, U.S. business insolvencies grew 44 percent last year, a rate that was expected to increase this year, fueled largely by real estate failures, according to Dan North of Euler Hermes, a global provider of credit insurance to businesses that publishes an annual global insolvency index. — Washington Post, September 1, 2008

“I think the (Federal Reserve’s) statement is pretty dovish on inflation. There is a lot more text discussing the weakness on the economy like consumer spending. There seems more emphasis on the downside risks to growth,” said Daniel North, chief economist at Euler Hermes in Owings Mills, Maryland. — ABC News, August 26, 2008

Today’s business failures ripple across the economy, triggering more failures. And when the financial system is crippled by losses, the hoped-for V-shaped recovery can flatten out into a wide-bottomed U, says Dan North, chief economist of Euler Hermes ACI, a North American unit of Germany’s Allianz Group that insures accounts receivable. North says that because of business failures, the number of insurance claims processed by his company was up 80% in the first six months of 2008 compared with a year earlier. — BusinessWeek, September 22, 2008

“(Circuit City is) definitely a buyer that’s concerning to us that a couple of years ago was not,” said Steve Lapsley, retailing industry manager for credit insurer Euler Hermes. Lapsley wouldn’t comment specifically on whether it is providing credit insurance to Circuit City’s suppliers. — CNNMoney.com, October 6, 2008

If you are particularly risk-averse, you may want to consider credit insurance. A credit insurer will pay you if a customer doesn’t. Travelon, a luggage manufacturer in Elk Grove Village, Illinois, has been buying credit insurance from a company called Euler Hermes since 2000, insuring all accounts worth at least $10,000, about 75 percent of Travelon’s receivables. If any one of those clients doesn’t pay, Euler covers 80 percent of the bill. Travelon’s premiums cost about $58,000 a year — less than a quarter of 1 percent of its revenue. — Inc. Magazine, September 2008

Euler Hermes ACI Chief Economist Dan North appears as a regular guest on the Fox Business Network.

Page 12: Foresight Magazine

800 Red B

rook Boulevard, O

wings M

ills, MD

21117