A New Bull Market Cycle in Emerging Market Equities

Economic

Stocks

Summary:

We see four pillars supporting the thesis for a new bull cycle in EM equities: improving macroeconomic fundamentals, an earnings cycle, a peak in the US dollar, and structural trends such as the energy transition and AI.

A decade of tech-driven US stock market outperformance has contrasted with tepid returns for Emerging Market (EM) stock indices. But past returns are not an indicator of future performance, and the drivers of markets over the next decade will be quite different from the ones over the last.

A better fit: relative GDP growth

Although it makes intuitive sense, it is misleading to assert that there is a direct relationship between a country’s GDP growth and its equity market performance. Since 1989, however, there has been a clear relationship between real GDP growth differentials and equity market relative performance. EM equities outperformed Developed Market (DM) (and US) markets between 1989 and 1994 and subsequently between 2001 and 2011. Both periods coincided with a significant increase in EM vs. DM economic performance (growth premium). Then, between 2012 to 2022, the EM growth premium declined, coinciding with the poor performance of EM equities vs. DM, despite some episodes of good EM absolute performance.

Since Covid, things have changed. According to the International Monetary Fund (IMF), 2020 DM GDP contracted 3.9%, while EM GDP declined by just 1.7%. EM then quickly bounced back to pre-Covid annual growth of around 4.0% as per Fig 1, while DM GDP growth remained tepid. The resilience EM GDP showed through the pandemic and over the last two years has reestablished a healthy growth differential, which the IMF expects will remain in place over the coming years.

A New Bull Market Cycle in Emerging Market Equities_1

Macro resilience

While growth is important, equity investors also care about downside risks. This renders GDP growth trivial without macro stability, and in the last five years, impressive EM GDP has been coupled with inflation falling more quickly than in DM. The IMF and the Bank of International Settlements (BIS) have put this macro stability down to sound fiscal and monetary policies, with a balanced fiscal expansion in the aftermath of the pandemic allowing for better debt dynamics in many EM countries.3 We agree, and this is reflected in the recent trend of more EM sovereign debt upgrades than downgrades by rating agencies. Upgrades are particularly notable for some of the significant equity markets, such as Brazil and India, as well as smaller ones such as Türkiye and Kazakhstan.

Earnings cycle

Solid macro lays a good foundation for equity performance. However, the most critical catalyst for a meaningful rebalancing of investor positioning towards EM equities will be a sustained increase in their earnings per share (EPS).

Over the last 25 years, the EPS of EM and DM rose by a similar pace: 6.5% for the former and 5.7% for the latter. The averages hide two distinct cycles. From 2000 to 2011, EM EPS rose by a whopping 17.2% per annum (p.a.). DM ex-US increased by 5.9% p.a, while US EPS growth was only 4.9% p.a. Then, over the last decade, this relative performance reversed, as EM EPS growth dropped to 2.3% p.a., DM ex-US was only 0.5% and US EPS increased by 6.4% p.a.

The first period of EM earnings divergence (2000-2011) was backed by a decade of important governance reforms across many sovereigns and corporations that started in the early 1990s. These reforms were a catalyst for deeper integration into global markets. Then, with China emerging as a major manufacturer for the rest of the world after the turn of the millennium, its huge demand for natural resources provided a tailwind for other EM countries. Unfortunately, the latter part of the EM bull market, from around 2009-12, became overexuberant. This led to macroeconomic imbalances via large external and fiscal deficits. The correction of this exuberance led to a sharp decline in earnings (2012-2016), which coincided with the first phase of US economic exceptionalism driven by low rates, the shale oil revolution and booming tech companies.

What we are seeing today is very much the reverse. The US is now the centre of over exuberance and macroeconomic imbalances – and probably due for a correction – while EM external and fiscal balances are largely healthy, setting a good foundation for earnings growth. After a two-year decline, 12-month EM EPS growth forecasts have been higher than the S&P 500 since October 2023 and have risen from 9% at the end of January to 25% at the end of August (vs. 10% for S&P 500).

Conclusion

The case for an outperformance of EM equities post beginning of US rate cuts is sound. Macro fundamentals across EM are solid, and many companies are well positioned to benefit substantially from long term structural drivers such as AI and energy transition. As the Fed cuts policy rates, EM central banks will be in the position to ease more aggressively. Against that backdrop, with the dollar having peaked, and EM earnings expectations improving, the structural under-allocation to EM equities is likely to change. The savvier investors will choose active strategies over passive or quasi-passive allocation, in an asset class where active management has a significant edge.

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FastBull Featured

Daily News

Economic

[Quick Facts]

1. Biden signs a bill to accelerate semiconductor chip manufacturing projects.

2. Fed's Barkin says price pressures may not fade as fast as expected.

3. OPEC+ set to go ahead with Dec oil output hike despite possible oversupply.

4. ADP data shows U.S. companies add more jobs than expected in Sept.

5. Japan's economics minister asks BOJ to help complete exit from deflation.

[News Details]

Biden signs a bill to accelerate semiconductor chip manufacturing projects

The White House announced that President Biden signed legislation that will exempt some U.S. semiconductor manufacturing facilities from federal environmental reviews that are receiving government subsidies. Without this new legislation, U.S. semiconductor chip manufacturing and research projects, worth $52.7 billion, could have been subject to federal reviews that might take years.

The bill has caused division within the Democratic Party, highlighting the challenges Biden faces in advancing his economic agenda while balancing ambitious climate goals. Critics argue that the bill allows companies to bypass critical steps designed to reduce potential harm to the environment and workers.

The legislation would reportedly exempt eligible chip projects from the National Environmental Policy Act (NEPA), which requires federal agencies to assess the potential environmental impacts of major federal actions before they can be implemented. The House of Representatives passed the bill last week, and the Senate unanimously passed it last December.

Fed's Barkin says price pressures may not fade as fast as expected

Richmond Federal Reserve President Tom Barkin, speaking at an economic conference at the University of North Carolina Wilmington, said that the rate decision in September reflected a recalibration of policy. Headline inflation is close to its target and unemployment is approaching its natural level after the federal funds rate has stayed at a high of 5.3% for more than one year. The current incongruous figure is the federal funds rate, which no longer needs to be so restrictive given the progress we've made.

There is still a lot of work to be done on inflation. While inflation has fallen back from its highs, it remains above our 2% target. I don't expect core inflation to fall too sharply until 2025, as we are still comparing it to the low inflation data from late last year.

The U.S. labor market is performing solidly, but the trend is not encouraging. The unemployment rate has risen since last year, while monthly hiring has slowed. However, layoffs remain low, as employers seem to be more cautious about cutting jobs after the labor shortages during the pandemic.

The labor market faces the dual risk that lower interest rates could stimulate demand and increase hiring, or that the negative trend could intensify further.

OPEC+ set to go ahead with Dec oil output hike despite possible oversupply

Despite signs of an oversupply in the oil market, OPEC+ has not changed its plan to gradually hike oil production starting at the end of the year. The group confirmed its plan to increase production by 180,000 barrels per day in December, two months later than scheduled due to fragile market sentiment.

Oil prices have risen more than 5% in the past two days after OPEC member Iran launched an attack on Israel, leading to an escalation of conflict in the Middle East. While lower oil prices have come as a relief to inflation-plagued consumers and central banks that have started interest rate cuts, it has put economic pressure on OPEC and its allies. Wednesday's OPEC+ Joint Ministerial Monitoring Committee meeting focused on the failure of Iraq, Kazakhstan and Russia to fulfil their production cut commitments, according to delegates who declined to be named. While these countries 'reaffirmed their strong commitment to the agreement,' most continue to exceed their production quotas and have yet to begin additional cuts to make up for the oversupply in previous months.

ADP data shows U.S. companies add more jobs than expected in Sept

U.S. companies added more jobs than expected last month, which was at odds with other indicators showing a cooling labor market. Data showed private sector employment rose by 143,000 in September, compared with an upwardly revised 103,000 increase in August.

The increase in employment represented a rebound after five consecutive months of slower job growth, especially in light of last month's data which was at its lowest level since March 2023. Even so, the three-month average fell to 119,000, one of the lowest levels since 2020.

Japan's economics minister asks BOJ to help complete exit from deflation

Japan's new Economics Minister Ryozo Akazawa said the Bank of Japan (BOJ) should decide on rate hikes carefully to avoid the risk of excessive cooling of the economy. "I don't think we have completely overcome deflation, and I still can't deny the possibility of slipping back into deflation. As long as I feel that way, I hope the central bank agrees with us that it needs to be more cautious about raising interest rates," Ryozo Akazawa said. He said consumers remain unconvinced that prices will continue to rise, given that wages and prices have barely increased in Japan for decades.

Akazawa, however, was not totally opposed to further rate hikes by the BOJ. Akazawa said,"If conditions are met, it would not be surprising to see monetary policy normalized." Japanese Prime Minister Shigeru Ishiba, on the other hand, said in a speech that it is appropriate for further interest rate increases now.

[Today's Focus]

UTC+8 14:30 - Switzerland CPI YoY (Sept)

UTC+8 22:00 - U.S. ISM Non-Manufacturing PMI (Sept)

UTC+8 22:40 - Minneapolis Fed President Kashkari Participates a Fireside Chat with Atlanta Fed President Bostic on Inclusive Economics

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Cohen

Economic

Waves of sanctions imposed by the Biden administration after Russia’s invasion of Ukraine haven’t inflicted the devastating blow to Moscow’s economy that some had expected. In a new report, two researchers are offering reasons why.

Oleg Itskhoki of Harvard University and Elina Ribakova of the Peterson Institute for International Economics argue that the sanctions should have been imposed more forcefully immediately after the invasion rather than in a piecemeal manner.

“In retrospect, it is evident that there was no reason not to have imposed all possible decisive measures against Russia from the outset once Russia launched the full scale invasion in February 2022,” the authors state in the paper. Still, “the critical takeaway is that sanctions are not a silver bullet,” Ribakova said on a call with reporters, to preview the study.

The researchers say Russia was able to brace for the financial penalties because of the lessons learned from sanctions imposed in 2014 after it invaded Crimea. Also, the impact was weakened by the failure to get more countries to participate in sanctions, with economic powers like China and India not included.

The report says that “while the count of sanctions is high, the tangible impact on Russia’s economy is less clear,” and “global cooperation is indispensable.”

The question of what makes sanctions effective or not is important beyond the Russia-Ukraine war. Sanctions have become critical tools for the United States and other Western nations to pressure adversaries to reverse actions and change policies while stopping short of direct military conflict.

The limited impact of sanctions on Russia has been clear for some time. But the report provides a more detailed picture of how Russia adapted to the sanctions and what it could mean for US sanctions’ effectiveness in the future.

Since the beginning of Russia’s invasion of Ukraine in February 2022, the US has sanctioned more than 4,000 people and businesses, including 80 percent of Russia’s banking sector by assets.

The Biden administration acknowledges that sanctions alone cannot stop Russia’s invasion — it has also sent roughly $56 billion in military assistance to Ukraine since the 2022 invasion. And many policy experts say the sanctions are not strong enough, as evidenced by the growth of the Russian economy. US officials have said Russia has turned to China for machine tools, microelectronics and other technology that Moscow is using to produce missiles, tanks, aircraft and other weaponry for use in the war.

A Treasury representative pointed to Treasury Secretary Janet Yellen’s remarks in July during the Group of 20 finance ministers meetings, where she called actions against Russia “unprecedented.”

“We continue cracking down on Russian sanctions evasion and have strengthened and expanded our ability to target foreign financial institutions and anyone else around the world supporting Russia’s war machine,” she said.

Still, Russia has been able to evade a $60 price cap on its oil exports imposed by the US and the other Group of Seven democracies supporting Ukraine. The cap is enforced by barring Western insurers and shipping companies from handling oil above the cap. Russia has been able to dodge the cap by assembling its own fleet of aging, used tankers that do not use Western services and transport 90 percent of its oil.

The US pushed for the price cap as a way of cutting into Moscow’s oil profits without knocking large amounts of Russian oil off the global market and pushing up oil prices, gasoline prices and inflation. Similar concerns kept the European Union from imposing a boycott on most Russian oil for almost a year after Russia invaded Ukraine.

G-7 leaders have agreed to engineer a $50 billion loan to help Ukraine, paid for by the interest earned on profits from Russia’s frozen central bank assets sitting mostly in Europe as collateral. However, the allies have not agreed on how to structure the loan.

Source: ARAB

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Bruegel

Economic

Introduction

Ukraine is not the only part of Europe vulnerable to missile and air attacks . However, Europe’s current defensive capabilities, in particular NATO’s integrated air and missile defence systems, do not provide full coverage of European critical infrastructure, let alone the full territory.

Experience in Ukraine and Israel shows that effective missile defence is feasible. It is also expensive. The high cost of air-defence systems such as the US-made Patriot or the German IRIS-T is one reason why European governments have invested insufficiently. A single Patriot missile battery costs around $1 billion and the build-up of a European air defence shield could easily amount to an investment in the hundreds of billions.

European Commission President Ursula von der Leyen has said she intends to build a “European defence fund” and to propose “defence projects of common European interest starting with a European airshield”. However, it is unclear, how such an airshield would be funded. Major upfront investments are difficult to fund from regular national budgets. Moreover, national and European budget rules, plus limited fiscal space, make it difficult for some European countries to borrow to fund expensive air defence equipment. Finally, if countries do it alone, they might invest insufficiently, neglecting the public good they are providing.

The fiscal rules that govern European Union countries could be sidestepped by issuing on an exceptional basis EU debt that would provide resources for this costly air-defence roll-out. This act of mutual assistance would free national budgetary resources and provide long-term funding stability, while also boosting the domestic defence industry. But such EU debt would have to be justified in EU law and implemented. In this Policy Brief, we propose the creation of an EU funding mechanism to internalise the positive externalities provided by national air-defence systems, whether in the context of the “drone wall , protection against air raids and cruise missiles or threats from ballistic missiles. Command-and-control structures meanwhile would remain in the NATO framework and ultimate national sovereignty would be preserved.

After a short discussion about how sovereignty concerns have so far impeded EU defence integration, we argue that air defence is a European public good. Because of the substantial costs and economies of scale, provisioning by any country would be insufficient – air defence would benefit from European funding. Adequate funding governance for air defence can be put in place to account for continuing differences between countries in preferences and for distributional effects. Moreover, since air defence is a major investment, there is a case to fund it via deficits. We provide detailed arguments for that. We then discuss the legal base for a European debt instrument that permits debt funding while respecting limitations in scope, quantity and time.

Sovereignty concerns

Defence and military capabilities are considered core sovereignty issues and reflect the ability of countries to effectively exercise state power (Dobbs, 2014). Some national constitutional courts have identified defence as a core function for the sovereignty of the nation state, and core defence capabilities would therefore have to remain under national control, making any significant transfer of competence possibly unconstitutional (GFCC, 2009). The sensitivity of defence as issue of national concern is further reflected in the very limited integration in the area of defence throughout the EU integration process after the French rejection in 1954 of the formation of a European Defence Community. Accordingly, the EU Treaties flag defence and military issues as areas of national competence, with EU-based defence activities limited in scope and constrained by unanimity voting.

European defence integration does however enjoy consistently high levels of public support (Mérand and Angers, 2014). Genschel and Jachtenfuchs (2015) identified the increasing integration – without federalisation – of core state powers, including defence, in the EU. Strategic threat perceptions can influence public opinion on European defence cooperation and integration – in particular the perception that Russia’s military activities in Ukraine threaten security – and increase support for the creation of a common European army (Graf, 2020).

Crises can counter the “constraining dissensus” in relation to defence integration (Burgoon et al, 2023), and there is both cross-border support for European defence and converging preferences on the actual design of such a policy. Unsurprisingly perhaps, a somewhat ad-hoc German proposal on air defence, the European Sky Shield Initiative (ESSI) , proposed in August 2022 by Chancellor Scholz as an initiative to strengthen the European pillar of NATO and build up capabilities in air defence, has attracted the participation and interest of more than 20 states. ESSI involves procurement, maintenance and use under NATO command of air-defence capabilities.

However, France is not part of ESSI and has criticised the initiative, in part because of its focus on US and Israeli defence companies. France’s criticisms also relate to differences in deterrence doctrines, and political, economic and industrial policy questions (Arnold and Arnold, 2023). Since the establishment of ESSI, some convergence has been achieved on these issues and French president Emmanuel Macron has recognised explicitly the importance of ESSI for countries without nuclear deterrence. To make EU-level debt funding for air defence acceptable, it will be important to strengthen interoperability of systems and include at least to some degree the French-Italian SAMP-T system alongside IRIS-T and other European systems.

In this context, EU funding for air defence could initially focus on R&D to advance interoperability. R&D funding could even focus on developing new EU systems able to intercept ballistic missiles. In a second step, EU funding would be used for the roll-out of such systems. While this approach may be politically more acceptable, such a staggered process risks taking too long. As Europe is currently vulnerable to air attacks, it is important to increase air-defence capabilities rapidly. In practice, it may therefore be necessary to advance along parallel R&D and procurement tracks. Purchases of the equipment necessary to protect critical infrastructure could start immediately, even if from foreign producers, while additional EU funding could be used to advance the development of EU systems.

If new EU debt were created to pay for air defence, purchases from US companies, as being done under ESSI, would not crowd out European industrial development. Moreover, while EU debt financing would be strictly limited in volume and scope to European air defence (mainly for legal reasons; see section 4.2), the financial investments would also provide long-term funding that would give the necessary stability to industrial policy and fiscal forward guidance for the industry to enhance production capacities. Building-up the air-defence capacities of domestic defence companies will provide a diversity of systems, making European air defence more resilient to possible disruptions related to foreign suppliers. In short, EU debt would allow short-term needs to be met through procurement from abroad while also nurturing the build-up of an EU defence industry.

Since air defence is an issue for Europe as a whole, any EU funding initiative should be open to European allies, including the United Kingdom and Norway, which are part of the same airspace that needs to be defended (and which are already part of ESSI). While our proposed EU borrowing mechanism would focus on EU procurement, non-EU allies could participate in some form.

Air defence as a European public good and its proper governance design

Why air defence is a European public good

A European public good (EPG) can be defined as a good not supplied at an adequate level without public intervention (Fuest and Pisani-Ferry, 2020), and which should be provided, at least partially, at EU level to internalise externalities and reap benefits of scale, notwithstanding potential differences in national or local preferences (Claeys and Steinbach, 2024). State-level defence has long been considered a public good but to what extent is defence a European public good? The EPG definition comes from the fiscal federalism literature (Tiebout, 1956; Oates, 1972; Alesina et al, 2005) and does not necessarily apply to the same extent to all aspects of defence.

In the EU and NATO, any national army provides to some extent a public good beyond its own security because it can be called up and contribute to collective defence via Article 5 of the NATO Treaty and Article 42(7) of the Treaty on the Functioning of European Union. This is a direct way of contributing to collective deterrence and thereby shows that national defence capacities are, at least to some extent, a European public good. Also, in case of threats from state and non-state actors that may use cheap drones and missiles to attack EU territory, border states play an important role in intercepting incoming threats to the benefit of the EU as a whole. As countries can, at least to some extent, count on assistance by others, there is an incentive to free ride on others’ provisioning of military services.

Air defence is particularly subject to strong scale effects and externalities (Beetsma et al, 2024): When it comes to threat detection, the more that radar and other detection systems are interconnected and the more data is shared, the easier it is to detect threats early on, reducing investment needs for each country. For aircraft, cruise missiles and drones flying at low to medium altitude, countries of first entry should typically act to neutralise the threat, thereby providing a public good to more distant countries that might have been targeted. Even for high-altitude ballistic missiles, detection and neutralisation can be done from countries other than those being targeted.

For example, a ballistic missile fired at the Netherlands will unlikely be intercepted only over the Netherlands. European air defence is therefore a particularly robust public good that few European countries could provide alone. Scale economies and shared benefits thus offer a strong rationale for providing the public good at European rather than national level. With the significant fixed costs for building up air defence, unifying national efforts can untap substantial savings.

The counterargument against air defence as an EPG is that the current threat is primarily Russia and therefore countries in Europe’s South and West may be less affected. It is perhaps no surprise that Spain and Italy have not reached the 2 percent of GDP NATO target for defence spending. However, Western Europe is not necessarily immune from the Russian threat. Moreover, threats are evolving. Future threats could come from other EU neighbours. For example, should North Africa succumb to Islamic State-style Islamists, drones could become a direct threat to Mediterranean countries.

Nevertheless, concerns about European defence integration persist. At the strategic level, there is a worry that an air-defence build-up would upset the balance of power and deterrence between Russia and Europe. This concern relates in particular to high-altitude deterrence, as provided through the Israel/US Arrow 3 system. It is also feared that air defence could attract investment at the expense of deep-strike capacity. In terms of scale and availability, ESSI has been criticised as relying too strongly on US-based systems, in particular the Patriot system, creating a strategic dependency on the US and limiting availability to the production capacities of the US company Raytheon (which produces the Patriot system). Finally, there is an industrial policy worry that European taxpayer money would boost US defence companies instead of advancing European systems from France and Italy, in particular SAMP-T.

EU countries are gradually converging on these issues. French president Emmanuel Macron has explicitly recognised the importance of ESSI for countries without nuclear deterrence. When it comes to the balance between deterrence and strike capabilities, there is a growing recognition that air defence cannot come at the expense of strike capabilities. When it comes to strategic dependence, missile manufacturer MDBA Germany is building a factory to produce Patriot missiles, though capacities might still be insufficient and dependencies could persist. And importantly, ESSI includes German systems such as IRIS-T.

Furthermore, drawbacks must be balanced against the advantages of the availability of US systems and their high performance. Moreover, increasing investment in domestic production combined with investments in interoperability should increase the resilience of European air defence against geopolitical risks. To make debt funding acceptable and to ensure Europe’s air defence industry thrives and that a diversity of systems is available, reducing strategic dependence on any individual supplier, it will be important to strengthen interoperability of systems and include SAMP-T systems, IRIS-T and other European systems in the European funding efforts. It would also be worth allocating a part of the EU funding to developing a European system that can rival current systems from abroad.

An adequate governance design for European air defence

Characterising air defence as an EPG does not necessarily imply that all its elements should be centralised at EU level (Claeys and Steinbach, 2024). Rather, the EU legal and institutional framework offers a menu of design options that allow the governance of the public good to be customised, guided by efficiency and the trade-offs described above.

One design option that would account for highly diverse policy preferences is ‘club good provision’, through which deeper defense cooperation would be pursued by some rather than all EU members contributing to defence as an EPG. The EU Treaties generally allow for club good provision through ‘enhanced cooperation’ (Demertzis et al, 2018; Fuest and Pisani-Ferry, 2019). One design option offering flexibility in governance would be the existing Permanent Structured Cooperation (PESCO) in defence cooperation in relation to research, procurement and armaments cooperation. Projects involving non-EU countries have also been pursued under the PESCO umbrella. PESCO could thus become the framework for some air defence equipment purchases and for enhancing R&D in air defence in collaboration, where applicable, with the European Defence Agency and the European Defence Fund.

Current frameworks overlap and do not intersect exactly. ESSI includes mainly EU members but also other allies Norway, the UK, Switzerland and Turkey. The PESCO cooperation framework covers 26 EU countries (Malta being the exception). The PESCO framework provides sufficient flexibility for at least the EU ESSI members to cooperate in PESCO projects. ESSI could become a new PESCO project, and its EU country members (out of the 26 PESCO members) could agree on a ‘club good’ based ESSI initiative.

The participating member states would agree among themselves on the arrangements for, and the scope of, their cooperation, and the management of that project. Integrating non-European countries into ESSI is possible under the PESCO architecture, having already been done previously with the integration of the US and Canada into PESCO Military Mobility projects.

The advantage of pursuing ESSI within PESCO is that suitable institutional governance exists that could provide the basis for joint debt financing and could also be used for greater cooperation in procurement and R&D. In particular, integrating ESSI into PESCO would allow resources from the European Defence Agency to be used, for example to enhance the interoperability of different systems and to invest in R&D, including for the French/Italian air defence system.

Providing air defence as public good can be customised depending on whether it is supplied in centralised or decentralised fashion. Our understanding is that, in the outline plan advanced by Commission President von der Leyen, the EU would play no operational role in air defence, which would remain solely the competence of member states within the NATO framework. Clearly, in a true ‘federal’ EU vision, military decision making, among other things, would one day be centralised, but that vision is not the framework of thinking in this Policy Brief, in which we consider concrete options for decision makers. Some elements of air defence however could be delivered at EU level, including procurement of air-defence systems (eg joint large-scale purchases of military equipment). For that option to advance, member states would have to agree on what systems are particularly suited for joint purchases and which are better procured with existing, though often slow, domestic procurement approaches. In case of a less-ambitious approach, procurement could remain national but under a joint framework contract. Joint debt issuance would not require the European Commission to decide on spending, as this would remain the responsibility of member states, or if centrally decided, subject to unanimity in the Council of the EU.

Finally, even if there is a strong efficiency case to supply air defence as an EPG, centralisation may have distributional effects. Joint procurement may create losers as well as winners and incumbent industrial players might seek compensation as they lose their (national) market shares. The political implications of this must be taken into account, while understanding that additional EU debt would grow the market for defence products substantially. In a growing market, it would be a mistake for incumbent industrial players and governments to merely seek to retain national market shares. Rather, they should accept the importance of cost effectiveness and competition in overall conditions conducive to more revenues.

It is thus true both that joint, as opposed to national, procurement of air defence systems can revitalise competition, break up national markets and threaten national ‘champions’ (Burgoon et al, 2023), while simultaneously these national companies could grow substantially, as shown by the extraordinarily positive stock market performance of European defence companies since 2022. Nevertheless, some compensation mechanisms may still be politically advisable to strengthen domestic defence industrial bases that would not benefit directly from EU-funded ESSI procurement. We thus recommend including TWISTER (the Timely Warning and Interception with Space-based Theatre surveillance project, led by MDBA) and the Franco-Italian SAMP/T in the purchases and the R&D phase. Joint debt issuance and joint procurement would thus also increase budgetary resources for such domestic defence systems. Another mechanism would be to adapt, where necessary, existing EU funds to cushion adverse effects felt by regions (eg Structural Funds or the Just Transition Fund).

Debt-financing ESSI

The economic rationale for EU debt funding

PESCO projects are generally financed by the participating countries. In terms of air defence, joint debt issuance could increase the resources to fund procurement. While procurement and funding would ideally be centralised to achieve efficiency gains, it is likely and possible that funds raised from issuance of EU debt would be first disbursed to EU countries, which would then spend them on ESSI projects in the context of PESCO.

The economic rationale for debt funding air defence is straightforward: building air-defence systems represents a huge upfront investment. Once the system is in place, operational costs are relatively small. Large upfront investments should be funded by deficits for tax-smoothing reasons, and to spread costs over the periods during which systems will be operational.

Legal implications of EU debt financing for air defence

The legal implementation of exceptional debt financing for ESSI is challenging but feasible. There are two major legal issues, the first related to the financing of defence from the EU budget, and the second related to debt-financing for EU defence expenditure. For both issues, the mechanism must evidently comply with EU law, but national constitutional law also poses constraints. In particular the German Constitutional Court’s concerns about EU debt should not be ignored in order to minimise legal challenges that could arise if decisions are brought before the German Constitutional Court.

There is a general restriction, stipulated in Article 41(2) of the Treaty on European Union, that prevents the EU budget from funding expenditure related to operations with military or defence implications. However, this provision has not stood in the way of the recent evolution towards an EU defence union. Despite its limited competence in defence, the EU has advanced joint procurement of defence equipment through the European defence industry reinforcement through common procurement act (EDIRPA, Regulation (EU) 2023/2418) and has stepped up production to sustain ammunition and missile deliveries from Europe to Ukraine through the Act in Support of Ammunition Production (ASAP, Regulation (EU) 2023/1525). These initiatives, built on the EU’s internal market and industrial policy competence (Articles 113 TFEU and 173(3) TFEU), are a combination of building up EU military capability and industrial capacity. These initiatives do not conflict with Article 41(2) TEU because they entail development of military capabilities, not defence operations (Fabbrini, 2024). Unlike these initiatives, ESSI would go beyond propping up capabilities through joint development by purchasing military equipment, though not operational deployment of ESSI capabilities. Article 41(2) TEU thus requires such purchases to be made outside the regular budget. The EU has been dealing with this restriction through the framework of the European Peace Facility, an off-budget fund that allows EU countries to purchase lethal and non-lethal military support.

In addition to basing ESSI on internal market and industrial policy competences, a proper legal basis to permit debt-based funding can be found in Article 311 TFEU (for borrowing) and in Title V of the TEU on Common Foreign and Security Policy, in combination with Article 122 TFEU (for spending). Our solution would introduce EU borrowing ‘off-budget’ and outside the regular EU budget (similar to the EU post-pandemic economic recovery initiative, NextGenerationEU, NGEU). Proceeds from credits that are bound to go into grants to finance ESSI would be so-called “externally assigned revenues”, as they were treated under NGEU. These revenues are not part of the annual EU budget, nor of the EU’s seven-year multiannual financial framework, because assigned revenues are not decided on under the annual budget procedure (CLS, 2020, para. 34).

Through such an ‘off-budget’ design, debt-financing of ESSI as defence expenditure would not violate the general ban on financing of defence from the EU budget. In any case, one must consider that the ban on using the EU budget for defence has two objectives. First, it seeks to protect neutral EU members from having to pay for military expenses. In our proposal, this protection is respected in any case through the Own Resources Decision (ORD, the decision of EU countries on resources for the EU budget), which would be the legal basis for debt funding. This decision requires unanimity, meaning approval by all EU members including neutral states. Second, the intention of keeping military expenses out of the EU budget is to preclude the European Parliament having co-decision rights (Achenbach, 2022). By keeping the parliament out of decision-making over defence and military issues, EU countries wanted to protect their prerogatives on these sensitive affairs. Again, our proposal foresees – just like under NGEU – no co-decision rights for the European Parliament, which is not able to vote on NGEU revenues and expenditure. In sum, the EU Treaties do not categorically preclude members from jointly debt-financing defence and military projects.

Since our proposal means designing EU debt financing similarly to how it was set up under NGEU, a distinction must be made between borrowing for ESSI purposes and spending on ESSI activities. The European Commission is enabled to borrow on the EU’s behalf by the ORD (Grund and Steinbach, 2023). The ORD requires a unanimous Council decision that designates the main sources of EU financing and requires ratification by each member state. The ORD authorises borrowing and specifies how the borrowing proceeds are to be used. This implies that borrowing for air defence requires a new ORD and hence requires ratification by EU countries in line with domestic constitutions (Article 311 TFEU). The German Constitutional Court has stipulated a number of limitations on EU debt financing that the overall borrowed funds may not exceed significantly the amount of own resources (GFCC, 2022; see footnote 18). Taking into account the existing stock of NGEU debt, there is thus a ceiling on permissible debt.

Spending of the funds raised needs to have a distinct legal anchor. For NGEU, this was the emergency clause in the EU Treaties (Article 122 TFEU), which permits the financing of targeted and temporary economic measures in exceptional situations. The emergency clause requires linking the use of borrowed funds to the addressing of the “exceptional occurrence” within the meaning of Article 122 TFEU. Despite obvious differences with NGEU, the creation of an ESSI-based air defence system can be likened to an emergency under Article 122 TFEU, in which EU countries permit mutual assistance to tackle an immediate security threat. Since individual EU countries are economically unable to finance ESSI, joint spending responds to the emergency situation. In conjunction with Article 122 TFEU, the EU can base ESSI expenditure on its CFSP competences under Title V of TEU (and the PESCO framework, in particular), which gives member states sufficient leeway to adopt an instrument like ESSI that aims at promoting defence and security.

Russia’s full-scale attack on Ukraine was a shock that has put at risk the security of the EU and its members. There is broad consensus that Russian territorial imperialism is a direct threat to EU security, which over time has intensified and increasingly threatens individual EU countries (see, for example, Cavoli, 2024).

The German Constitutional Court further ruled that debt financing must be limited in duration and substance (GFCC, 2022). A military assault on an EU immediate neighbourhood country can be considered an “historically exceptional case” in line with the court’s findings (GFCC, 2022). Even today, the direct threat of a Russian attack on EU territory is visible. Increased hybrid attacks and stray missiles reportedly reaching EU territory are among the indicators of the immediacy of the threat, as is the strong build-up of Russian military production capacities (Wolff et al, 2024). Each EU countries individually would not be able to protect its skies sufficiently. To account for the balanced-budget principle, the ORD must provide for sufficient future genuine own resources to ensure repayment of the debt. This is necessary to counterbalance the debt resulting from the borrowing by an asset, which justifies its off-budget treatment (CLS, 2020).

NGEU has been implemented through national Recovery and Resilience Plans, based on Article 175 TFEU, which follow a certain bottom-up logic with EU countries proposing projects which are then approved by Commission and Council. This approach ensured member-state ownership and a fair distribution of means. For air defence, there is no need to rely on Article 175 TFEU as a distributional device. Rather, the PESCO framework under Article 46 TEU offers the appropriate framework for the Commission and EU countries to decide which systems should be procured through joint purchases, or which should continue to be procured by member states – a decision that should be guided by cost-efficiency considerations.

Conclusions

The increased threat perception has shifted sentiment in Europe and the building up of defence capabilities has increased in importance in many countries. Surveys also indicate that citizens want the EU to play a greater role in defence. It is therefore no surprise that the German initiative to build up a European air defence system – ESSI – has been welcomed and endorsed by more than 20 European countries. Yet, France and Italy in particular have expressed some reservations about the initiative, even though some strategic convergence became visible during 2023.

Joint EU debt funding would be appropriate to boost European air defence. Joint funding can be justified by the fact that air defence is an EPG with significant externalities and spillovers. Debt funding is appropriate since air defence system build-up requires high upfront costs. Such debt funding could follow a model close to NGEU. Such a legal construction would be tenable.

Policymakers should act rapidly to set up such a major EU debt programme to boost European security in a spirit of solidarity between European countries. This would free-up national fiscal resources for other urgently needed defence systems. ESSI should be adjusted to take into account justified industrial policy concerns and to support R&D into the interoperability of systems and the enhancement of European technology in air defence. Finally, policymakers must find ways to include non-EU ESSI members in the effort. On the whole, EU debt would allow European defence efforts to be advanced greatly in a highly threatening security environment. Joint EU debt funding would internalise the major security externalities of air defence, be treaty compatible and politically highly welcome, all without detracting from EU industrial policy objectives.

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Alex

Economic

The Bank of Korea's (BOK) climate policy ranked 16th among the Group of 20 members' central banks, a drop of three positions from two years ago, a report showed.

In its recent report, "The Green Central Banking Scorecard," Positive Money, a London-based nonprofit organization, placed the BOK 16th regarding climate policies out of the 20 central banks, assigning it a grade of D-.

France, Germany and Italy, all part of the European Union, secured the top three spots, with the European Central Bank coming in fourth. Brazil and China's central banks ranked fifth and sixth, respectively. Despite the global significance, the U.S. Federal Reserve's ranking fell from 16th to 17th.

This indicates that the BOK's initiatives are perceived as falling short of global standards despite its recent efforts, according to Solutions for Our Climate (SFOC), a Seoul-based nonprofit.

In 2021, the BOK issued a paper titled "Bank of Korea's Response to Climate Change" to outline its approach to addressing the issue and made various formal commitments.

This February, the central bank created an office for sustainable growth and pursued policies such as promoting related research, expanding environmental, social and corporate governance investments and limiting investments in coal and fossil fuels in foreign assets.

However, the report refuted the BOK's claim that the development of the related strategy was "constrained due to the lack of green certification procedures and the scarce availability of green bonds."

It stated that the Korean Green Taxonomy includes guidelines on issuing green bonds, the most commonly issued securities by corporations and financial institutions in Korea.

The research emerged as climate change has increasingly become a critical responsibility for central banks. It drives up the cost of living and hinders economic activities due to natural disasters.

According to the BOK's separate report published in August, the BOK projects that about 10 percent of Korea's inflation since last year can be attributed to extreme weather events like heat waves and heavy rainfall. These events have also reduced the nation's industrial production growth rate by an average of 0.6 percentage points per year.

"The emphasis on climate action by central banks worldwide is clear evidence of the growing impact of climate change on inflation and economic growth," said Go Dong-hyun, head of the SFOC's climate finance team.

Experts agree that the BOK's efforts should go further.

Choi Gi-won, senior researcher at the Institute for Green Transformation, noted that the bank "should actively consider and implement monetary policy tools such as green finance intermediary support loans, climate impact assessments for its collateral and lending and green bond purchase programs."

Source: Koreatimes

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Warren Takunda

Cryptocurrency

Political

Commodities including gold and crude oil rose as the specter of war looms in the Middle East. Still, Bitcoin is moving in the opposite direction, leading to renewed debate over whether it’s a safe-haven asset.

Gold prices gained 1.4% on the day to reach $2,665 per ounce on Oct. 1, just shy of its all-time high, according to Goldprice.org. Meanwhile, crude oil prices spiked as much as 7% to reach $72 per barrel.

Bonds and the United States dollar also climbed following a major missile strike by Iran targeting sites across Israel late on Oct. 1. Israel’s air defenses shot down most of the 180 incoming missiles, according to reports.

“The escalating conflict in the Middle East has prompted investors to seek security in gold, bolstering its appeal amidst broader market uncertainty,” said Li Xing, financial markets strategist consultant to Exness.

Bitcoin, often referred to as a safe-haven asset, did the opposite, tanking more than 3% over the past 24 hours.

The asset dropped by almost $4,000, falling from an intraday high of $64,000 on Oct. 1 to bottom out at $60,315 at 20.40 UTC on Oct. 1. It has since recovered marginally to trade at $61,800 at the time of writing.

According to Coinglass, 154,770 traders were liquidated over the past 24 hours with total liquidations of about $521 million.

Israeli Prime Minister Benjamin Netanyahu has since promised retaliation for the attack.

“Iran made a big mistake tonight — and it will pay for it,” he said in a statement. Bitcoin Tanks, Gold Rebounds as Israel Vows Iran 'Will Pay' for Attack_1

BTC’s response to Iran’s airstrike. Source: TradingView

It was not the first time this scenario has played out. Bitcoin prices plummeted more than 8% on April 13 after Iran launched a drone attack on Israel.

Bitcoin questioned as a safe haven asset

Jeroen Blokland, founder of the Blokland Smart Multi-Asset Fund, was among those who said investors are selling BTC to buy gold, while Adam Cochran quipped about it being a “safe haven.”

Meanwhile, precious metals analyst Jesse Colombo told his 169,000 X followers that Bitcoin and crypto always tank when there are geopolitical fears, unlike precious metals, before adding:

“That confirms my long-held belief that crypto is not a safe haven. It's yet another risk asset just like high-flying tech stocks.”

US tech stocks also tanked on Tuesday, with Apple and Nvidia sinking about 3% and the Nasdaq 100 losing more than 2%.

However, BlackRock CEO Larry Fink once said that BTC could still be an alternative inflation hedge asset, while speaking to Fox Business in July 2023:

Head of research at 10x, Markus Thielen, told Cointelegraph that Bitcoin was initially designed as a peer-to-peer electronic cash system, not a safe-haven asset, before adding:

“Bitcoin is still maturing and has yet to fully transition into its potential role as a gold substitute, which some believe will occur if governments outlaw individual gold ownership.”

He said that until then, “Bitcoin’s price will continue to be influenced by economic and liquidity cycles,” and the current economic outlook remains weak.

Source: Cointelegraph

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Justin

Economic

HSBC Holdings plc’s asset management arm has launched a fund that will help private equity firms borrow against their portfolios, its first such offering as part of an expansion of its alternative credit business.

The fund, which originates net asset value loans, is expected to raise as much as €1 billion (RM4.63 billion), Borja Azpilicueta, the head of global capital solutions for HSBC Asset Management, said in an interview with Bloomberg News. HSBC AM is expecting the fund to make between 10 and 15 loans backed by private equity portfolios, the majority of which are set to be investment-grade.

“We think a lot of the focus on NAV financing is a result of PE moving to a new phase with longer hold periods,” Azpilicueta said.

Net-asset-value, or NAV, lending has grown in popularity in recent months, as private equity firms have struggled to return cash to investors given a lack of deals to exit their investments. This type of funding allows firms to issue debt secured against the net asset value of the portfolios they manage.

“We’re going to have a strong focus on the use of proceeds of these transactions, looking mainly at financing deals to grow portfolios,” Azpilicueta said.

The NAV strategy follows the launch of HSBC AM’s revolving credit facility strategy in November 2023, which invests in revolvers issued to private equity-owned businesses across Europe. HSBC AM’s alternatives business had US$71.1 billion (RM296.24 billion) in combined assets under management and advice at the end of June, with US$6.6 billion dedicated to alternative credit.