Japan
Loose Money and a Turn Towards Fiscal Discipline
By Takehiro Sato, Robert Alan Feldman & Takeshi Yamaguchi | Tokyo
Mild dip expected in 1H10. Japan has begun to recover in 2009 along with other nations, but the recovery momentum faces several short-run barriers. On the fiscal side, we expect changes in the composition of expenditures to slow public works investment from Jan-Mar 2010. We also expect adverse conditions to persist in the employment and earnings climate. In manufacturing, we anticipate cuts of surplus production capacity and of regular employment. Signs to the downside are already evident in economic indicators. The current conditions DI (diffusion index) in the November Economy Watchers' Survey recorded the worst MoM decline since the survey began. This DI leads the economy by about three months, so it suggests another soft patch starting in Jan-Mar.
Given our outlook for a growth lapse in Jan-Mar 2010, manufacturers' performance will likely deteriorate. However, we do not think the impact on F2011 (ends March 2011) corporate earnings will be so significant. We look for profit to grow 15% in F11 and 10% in F12 due to strict cost control. That said, the profit decline in F09-F10 was very substantial, so we do not believe that corporate earnings will recover over the next two years to the F08 level.
Additional monetary easing is likely. At the special Monetary Policy Meeting (MPM) on December 1, the BoJ announced a re-expansion of special lending, which it had previously cut when it terminated the facility for corporate financing at the October MPM. Now, the BoJ will provide three-month term money at a fixed rate of 0.1% and up to JPY10 trillion, thereby eventually forcing down term money rates.
The BoJ indicated that it could opt for further measures depending on economic developments. In this sense, we doubt that the December 1 special MPM marked the end of new easing measures. With the economy at a standstill, we expect that any improvement of the output gap will be delayed, keeping baseline prices (core-of-core) in deep negative territory. We believe that the DPJ government will see this as an intensifying issue ahead of the Upper House elections in July 2010.
Given the above, we expect more accommodative policy ahead, including (1) enhanced provision of funds, (2) repeated rollover of JGBs held by the BoJ and stepped-up Rinban operations (JGB purchasing), (3) unsterilized FX intervention, and (4) stronger commitment to policy duration and rate cuts. We think the first two measures are quite likely, and 1H10 is the probable timing. However, the market may well regard this as insufficient, if the government is serious about tackling deflation. On the other hand, we expect the exit timing for Japan to slip beyond Jul-Sep 2011. Indeed, the BoJ itself anticipates deflation to continue for three years through F12 in its Outlook Report from October 2009.
Ultimately, if the government is serious about beating deflation, it could adopt an inflation target. To date the BoJ has consistently played down this option, maintaining that under deflation there are no means of achieving an inflation target. However, Japan could follow the example of the UK, where the government has set an inflation target but handed the central bank a mandate to achieve it. As market expectations for inflation would kick in under these circumstances, the BoJ would likely respond by buying more JGBs. The government/MoF could then tilt towards a weak yen policy, in line with the monetary easing options listed above. A policy of strengthening the home currency during deflation would be a contradiction. The macro stance consistent with escaping deflation is a combination of further monetary easing and a weaker home currency. We expect Japan's macro policy to turn in this direction in 2010.
Credible commitment to mid/long-term fiscal discipline is essential. For fiscal policy, the prospect of a huge shortfall in tax revenues has spread concern about the sustainability of Japan's fiscal situation. However, we do not believe that Japan faces an imminent fiscal collapse, even with the larger fiscal deficit and debt load. We have confidence that 2% long-term yields, a level that has rarely been breached in the last ten years, remains a firm resistance level, so long as fiscal reform policies are clarified soon.
To regain investor confidence, mid/long-term targeting of the primary balance is key to averting a debt crisis. In 1H10, the government will work on preparing a medium-term fiscal framework of revenue forecasts and outline expenditures for 2011-13. These forecasts for revenue and spending will then form the assumptions in drafting a budget to cover multiple years from F12. This has the potential to significantly alter the budget compilation process from a bottom-up exercise to more of a top-down one. Earlier attempts were made under the LDP to formulate a broad budget framework based on macro forecasts of the Council on Economic and Fiscal Policy, but this time we think the chances of success are greater, given that politicians are taking a guiding role in the budget drafting process. If revenue projections in the medium-term forecasts act as a ceiling for budget spending as a whole, fiscal discipline could be enhanced to a greater extent than under the practice up to now of compiling the budget at the level of individual ministries.
China
A Goldilocks Scenario in 2010
By Qing Wang, Denise Yam, CFA | Singapore & Steven Zhang | Shanghai
We expect the Chinese economy to deliver stronger, more balanced growth with muted inflationary pressures in 2010, featuring 10% GDP growth and 2.5% CPI inflation. This baseline forecasts hinge on two key assumptions: i) the strong domestic demand in 2009 is largely sustained; and ii) the recovery in G3 economies remains tepid (see Global Forecast Snapshots: ‘Up' without ‘Swing', September 10, 2009).
The tight supply of raw materials and energy inputs has been a significant headwind to rapid expansion of the Chinese economy in recent years. When economies in the rest of the world are also in an expansionary phase of the cycle, any incremental demand from China tends to drive up the global prices of commodities, generating inflationary pressures and making it a challenge to deliver a Goldilocks scenario - a mix of high growth and low inflation.If, however, the recovery of the rest of the global economy were to remain tepid in 2010, it would help China to benefit from relatively low commodities prices for a reasonably long period of time until the economies of its competitors for the same limited amount of supply of commodities recover. This potentially creates a ‘window of opportunity' for China to deliver a Goldilocks scenario.
We forecast China's GDP growth at 10% for 2010 and think that the growth drivers are likely to become more balanced. The aggressive policy responses so far this year will likely continue to fuel rapid investment growth in the rest of 2009. Also, we expect property investment to accelerate in 2010, partly offsetting the slowdown in infrastructure investment expected to materialize because of the high base in 2009. Private consumption is likely to improve steadily through 2010 as consumer confidence and employment improve. We expect export expansion to resume in 2010 following a sharp contraction in 2009, which, together with a recovery in profits, should help underpin non-real estate private investment.
In terms of trajectory, while the 2Q09 rebound represents a sharp bounce from the cyclical trough, we expect the sequential growth rate to return to a more sustainable 2.0-2.5% in the quarters ahead. Nevertheless, we project that the year-on-year growth rate is set to accelerate further in the next few quarters, surging to double-digit rates by 4Q09 and peaking in 1Q10, before tapering off - on the base effect - toward a more sustainable high-single-digit level. The moderation in growth rate over the course of 2010 would reflect acceleration in private consumption and investment (e.g., property investment) and recovery in exports, partly offset by a smaller dose of policy stimulus.
A Goldilocks Scenario in 2010: Muted Inflationary Pressures
Despite strong headline GDP growth, concern about possible high inflation in China in 2010 is unwarranted, in our view. We forecast average CPI inflation at about 2.5% in 2010. Of note, we caution that predicting high inflation in 2010, based on the strong growth of monetary aggregates so far this year, could err on the side of being too simplistic and mechanical.
• First, the strong headline M2 growth in 2009 substantially overstates the true underlying monetary expansion, as it fails to account for the change in M2 caused by the shift in asset allocation by households between cash and stocks. We estimate that the growth rate of adjusted M2 - the rate that truly reflects the underlying economic transactions - is much lower than suggested by the high growth of headline M2 (see China Economics: Worried About Inflation? Get Money Right First, October 19, 2009).
• Second, generally weak export growth, which we think could be a proxy for the output gap in China, will remain a strong headwind containing inflationary pressures. These two demand-side factors combined would suggest that the 2000-01 situation - featuring relatively high money growth but relatively low inflation - is likely to be repeated in 2010.
• Third, from the supply side, while our commodities research team expects commodities prices to rise steadily in 2010, they do not foresee a significant surge in prices. They project crude oil at about US$85 per barrel in 2010 (see Crude Oil: Balances to Tighten Again by 2012, September 13, 2009). Assuming the cost pressures stemming from these supply-side shocks are able to pass through the supply chain to be reflected in the corresponding price increase of downstream products without much constraint from the demand side, we forecast a similar trajectory of CPI inflation for 2010 to the one derived from demand-side analysis (see China Economics: Inflation Outlook in 2010: A Supply-Side Perspective, November 1, 2009).
A Goldilocks Scenario in 2010: Policy Normalization
The super-loose policy stance is to normalize but remain generally supportive in 2010. In view of the inflation outlook, we expect the current policy stance to turn neutral at the start of 2010 as the pace of new bank lending creation normalizes from about Rmb10 trillion in 2009 to Rmb7-8 trillion in 2010. The M2 growth target will likely be set at 17-18%, in our view.Policy tightening in the form of reserve requirement ratio (RRR) hikes and base interest rate hikes is unlikely before mid-2010, in our view. If, however, excess liquidity stemming from large external balance of payment surpluses were to emerge earlier than expected, we would not rule out the possibility of the RRR hike cycle starting as early as the beginning of 2Q10. Indeed, with inflationary pressures likely muted, the monetary policy priority in 2010 is likely to be on liquidity management through RRR hikes.
Specifically, we expect the PBoC to hike base interest rates in early 3Q10, when we expect CPI inflation to have exceeded 3.0%Y in some months. However, since we forecast CPI inflation to moderate in 2H10, we expect no more than two 27bp rate hikes over 2H10, the primary purpose of which is to manage inflation expectations. In view of the current de facto peg of the Rmb against the USD, the timing of China's rate hike will also hinge on that of the US Fed, in our view. In particular, we do not expect the PBoC to hike interest rates before the Fed does. Incidentally, our US economics team expects the Fed to raise interest rates in 3Q10 (see Richard Berner and David Greenlaw's Hiring Still Poised to Improve Early in 2010, November 9, 2009).
We maintain our long-standing view that the current renminbi exchange rate arrangement will remain unchanged through mid-2010. While we believe an exit from the current regime of a de facto peg against the USD may occur in 2H10, any subsequent renminbi appreciation against the USD is, in our view, likely to be modest and gradual (see China Economics: An Exit Strategy for the Renminbi? June 9, 2009 and China Economics: A Dialogue on the Renminbi, November 11, 2009).
Looking ahead, China is likely to repeat a situation similar to that during 2005-08, featuring strong expectations of renminbi appreciation, ‘hot money' inflows, abundant external surplus-driven liquidity (as opposed to the current abundant liquidity due to loose monetary policy), and the attendant upward pressures on asset prices.
Indeed, against a Goldilocks macroeconomic backdrop, coping with rising asset price inflation pressures will likely become an important challenge to policymakers in 2010. To this end, ‘containing financial leverage' in the economic system is likely to be a top policy priority with a view to minimizing systematic risks in the event of a bursting of an asset price bubble. This could entail a variety of measures:
• Strict mortgage rules for homebuyers;
• Enforcing restrictions on margin trading in the stock market;
• Strict capital adequacy requirements for banks;
• Asymmetric liberalization of external capital account controls that induce capital outflows (e.g., through QDII programs) and discourage capital inflows; and
• Attempting to prevent one-way plays on the Rmb exchange rate against the USD that would induce hot money inflows.
China's Super-Cycle in a Globalized World Economy
The Goldilocks scenario in 2010 should be considered as a phase of China's super-cycle in a globalized world economy that comprises ‘overheating in 2007', ‘imported soft landing in 2008' and ‘policy-induced decoupling' in 2009. The Chinese economy was overheating in 2007, with GDP growth of 13% and CPI inflation of about 5%. We envisaged an ‘imported soft landing' scenario in 2008, which hinged on two key calls:
a) A US-led global downturn that would slow the rapid expansion of China's exports, thereby helping the economy to cool off; and
b) A muddling-through style for macroeconomic management - i.e., as external demand weakened, domestic policy tightening would not be followed through consistently and would even be eased over the course of the year (see China Economics: Journey into Autumn: An Imported Soft Landing in '08, December 3, 2007).
The ‘imported soft landing' indeed played out in most of 2008. However, it was disrupted and derailed by the onset of the Great Recession, such that China's economy suffered a hard landing in 4Q08-1Q09 (see China Economics: Outlook for 2009: Getting Worse Before Getting Better, December 9, 2008). Indeed, when turmoil of such global scale hit, there was an initial, indiscriminately strong negative effect from the shock on every economy that is deeply integrated into the global economy.
The strength and speed of policy responses in the immediate aftermath of the turmoil were, however, quite uneven among countries, resulting in different patterns of post-crisis recovery. China is a case in point. The aggressive policy response by the Chinese authorities helped translate China's ‘strong balance sheet' into a ‘decent-looking income statement', which distinguishes China from those countries that either suffer from a paralyzed financial system or are unable to launch strong pro-growth fiscal or monetary policy responses due to weak fiscal and/or external balance of payments positions. This makes China the first major economy to recover from the global market turbulence with strong momentum, effecting a policy-induced economic decoupling between China and the rest of the world (see China Economics: Policy-Driven Decoupling: Upgrade 2009-10 Outlook, July 16, 2009).
Specifically, a ‘Goldilocks recovery scenario' has indeed played out: the government's growth-supporting policies enable asset reflation, which underpins consumer and investor confidence and prevents the harsh adjustment in domestic consumption and private investment (e.g., real estate) in 1H09 (see China Economics: Property Sector Recovery Is for Real, May 15, 2009). The shallower trough in the economic cycle is then followed by recovery in activity, initially spearheaded by fiscal stimulus (3Q09), and then by a tepid recovery in external demand (4Q09) (see again China Economics: Policy-Driven Decoupling: Upgrade 2009-10 Outlook).
In the aftermath of the Great Recession, if the strength of China's domestic demand in 2009 can be sustained into 2010 and meanwhile the recovery of the rest of the global economy were to remain tepid, it would make China a potential beneficiary of relatively low commodities prices for a relatively long period of time until other major economies - which compete for the same limited amount of supply of commodities - recover. This potentially creates a window of opportunity for China to deliver a Goldilocks scenario.
Sustaining the Goldilocks scenario beyond 2010 would be a tall order, however. Against the backdrop of a potentially stronger recovery in global economy in 2011, the balance between growth and inflation in the Chinese economy will be more difficult to strike. This is a key reason why we tentatively forecast a mix of lower growth and higher inflation for 2011, while noting the tremendous uncertainty at the current juncture.
Alternative Scenarios in a ‘Four Seasons' Framework
The Goldilocks scenario is our base case. The risk to this base case forecasts relates to two types of uncertainties: a) the economic outlook in G3 nations; and b) domestic policy stance. Along the two dimensions of uncertainty, we envisage four potential scenarios in 2010 by adapting the ‘four seasons' framework that we employed before.Autumn features a combination of tepid G3 recovery and normalized policy stance in China that would deliver a ‘Goldilocks' scenario. We assign a 70% subjective probability to this scenario.
Summer features a combination of vigorous G3 recovery and normalized policy stance in China that would result in ‘Overheating'. If the G3 economic recovery in 2010 were to be much stronger than expected, China's export growth and thus industrial capacity utilization, as well as global commodity prices, could both surprise to the upside, likely resulting in higher GDP growth and stronger inflationary pressure if the policy stance were to remain unchanged. We think this is the most likely alternative scenario and assign a 15% subjective probability.
Spring features a combination of vigorous G3 recovery and aggressive tightening that would help achieve a ‘Policy-induced soft landing'. To realize this scenario, the timing and modality of policy tightening would be absolutely the key. However, this tends to be difficult to achieve in China. Administered interest rates and an inflexible exchange rate arrangement mean that the Chinese authorities have few available policy tools that allow for discretionary tightening with engineering precision. We therefore assign only a 5% probability to this scenario.
Winter features a combination of tepid G3 recovery and aggressive tightening in China that would lead to a ‘Policy-induced double dip'. The key headline macroeconomic indicators (e.g., the year-on-year GDP and export growth) may improve rapidly because of the low-base effect in the coming quarters. Policymakers may turn complacent and launch a round of aggressive tightening for fear of economic overheating despite a tepid G3 recovery. This would likely derail a recovery, causing a double-dip in economic growth. We assign a 10% probability to this scenario. On the other hand, the National Bureau of Statistics (NBS) has decided to start publishing quarter-on-quarter GDP growth rate data in 2010. If the official data release were to show a relatively low quarter-on-quarter growth rate despite a relatively high year-on-year growth rate in 1Q10, it would help guide the policy debate and therefore lower the risk of potential premature policy tightening, in our view.
A Post-Crisis Reflection on the Chinese Economy
It would be imprudent to call for a cyclical Goldilocks scenario in an economy built on a growth model that is structurally flawed. The typical concerns about the sustainability of China's economic growth are based on several key structural imbalances in the economy, including over-investment, under-consumption and large and persistent current account balances. Some China observers even predict that if these structural imbalances were left unaddressed, the Chinese economy would eventually implode.
However, in a post-crisis reflection on China's economy, we conclude that the popular concerns about such structural issues as ‘over-investment' and ‘under-consumption' in China are overdone and that the growth model is still generally sound.
First, with ‘over-investment' the current buzzword in the policy debate, much attention has been paid to the high investment-GDP ratio. However, we believe that a more important phenomenon in this regard is the high national savings rate in China. To the extent that the high investment ratio is a function of the high national savings ratio in China, discussing over-investment without discussing the high saving ratio loses sight of the big picture, in our view.
Second, China's high national savings rate is a generational phenomenon. It is primarily a function of such secular forces as Chinese demographics, largely shaped by China's ‘one-child' policy and slow adjustment in households' spending habits against the backdrop of rapid economic growth. The ‘one-child' policy artificially compresses the demographic evaluation in a window of some 30-40 years and lowers the dependence ratio sharply in a much shorter period of time in China than in other countries where aging is a natural, multi-decade process. The low dependence ratio substantially raises the saving ratio. While households' income increases rapidly in line with overall economic growth, personal consumption habits may take years and even decades to change. This results in a high savings ratio, which is often attributed to ‘cultural factors'. While other structural factors such as lack of social security and policy at SOEs may have also contributed to the high saving ratio in China, we view their impact as either marginal or an indirect reflection of the abovementioned secular forces (see China Economics: The Virtues of ‘Over-Savings': A Post-Crisis Reflection on Chinese Economy, September 27, 2009).
Third, a popular argument of ‘over-investment' in China is the high growth rate of fixed-asset investment. However, the rapid investment growth is driven primarily by infrastructure investment rather than investment in manufacturing sectors that suffer from overcapacity. Infrastructure investment actually lagged other types of investment by a wide margin in the past few years. Moreover, the investment projects mainly involve railways, intra-city subways, rural infrastructure, low-income housing and post-earthquake reconstruction, which are quite different from the infrastructure projects that were carried out in the context of the Asian Financial Crisis a decade ago.
Both rounds of infrastructure investment boom helped boost domestic demand in the face of negative external shocks in the short run. However, their medium-term implications are quite different: while investment in the immediate aftermath of the Asian Financial Crisis laid the foundation for a subsequent takeoff in China's manufacturing sector and hence exports, the current investment boom should facilitate urbanization and help to lay the groundwork for a potential consumption boom in the years to come, in our view (see again China Economics: The Virtues of ‘Over-Savings': A Post-Crisis Reflection on Chinese Economy).
Fourth, much of the concern about over-investment is based on the notion that investment is derived demand (e.g., investment to build a factory that produces widgets) instead of final demand (e.g., consumer demand for the widgets). When final demand like private consumption or exports is weak, it will eventually translate into weak investment demand. However, the line between derived demand and final demand is blurred when it comes to such urbanization-related infrastructure investment as intra-city subways, rural infrastructure and low-income housing. For a rapidly growing, low-income country like China, the nature of these investments is final demand, as faster and more convenient travel is as desirable now as more food and clothing, in our view.
Fifth, we argue that a more meaningful cross-country comparison in this regard should be about the capital-labor ratio in the economy. On this score, China's capital-labor ratio, or the capital stock per capita, is, not surprisingly, way below that in more advanced emerging market economies (e.g., Korea, Taiwan), let alone the industrialized economies (e.g., US, Japan), suggesting much upside for investment expansion. A key question in this underestimation of service consumption in China is the consumption of housing, in our view. Based on official statistics, we estimate that consumption of housing accounts for only about 3-4% of personal consumption in China. This seems to us too low to be even close to the reality. As a comparison, consumption of housing represents about 16% of personal consumption expenditure in the US and 6.6% in India. We think that an important reason for the seemingly low housing consumption in China is that the imputed rent of owner-occupied housing is not appropriately accounted for. In other words, the statistical methods used in the US and China to estimate the consumption of housing are quite different. The fact is that the house ownership ratio in China is over 80%.
Another important source of underestimation of service consumption in China is personal spending on healthcare, in our view. While the share of spending on healthcare in the US is 15-16% of total PCE, this share in China is only about 6%. However, there is no shortage of anecdotal evidence suggesting that there are substantial gray and black markets in health spending in China - which are not captured by official statistics.
Actually, the underestimation of the importance of the service sector was more serious before the substantial upward revision of GDP in 2005 following completion of the first nationwide economic census. In the 2005 GDP revision, China's 2004 GDP level was revised up by 16.8%; 93% of the increase stemmed from a substantial upward revision in the service sector, such that its share was lifted from about 32% to 41%. In explaining the revision, the NBS noted that China had long been using the Material Product System (MPS), which was developed under the centrally planned economic system in its national accounts statistics until the 1980s, resulting in ‘very weak' statistics for the service sector.
The second nationwide economic census has reportedly been completed this year and the key results will likely start to be released next year. The potential revision of the historical national account data will likely result in another significant upward revision of the share of the services sector in GDP, in our view. Incidentally, the first nationwide economic census was completed in 2004 and the revised national data (e.g., GDP) were released in December 2005. With the benefit of hindsight, there appears to have been a re-rating in the H-share stock market, as investors realized that the structural imbalances in the economy were less serious than indicated by the pre-revision data.
Market Implications
Goldilocks cyclical conditions, together with structural soundness, should be positive for risk assets, in our view. Morgan Stanley's Asia/GEMs strategist, Jonathan Garner, gives China the biggest country Overweight (see Asia/GEMs Strategy: 2010 GEMs Outlook: Headwinds Building but Further Upside Likely, November 9, 2009). Moreover, Morgan Stanley's China equity strategist, Jerry Lou, is also bullish, citing potential further upward re-rating from the current fair levels as earnings accelerate (see China Strategy: 2010 Outlook: Equities in Transitional Goldilocks, November 11, 2009).
Challenges in the Long Run
Notwithstanding our generally positive outlook for the Chinese economy in the near term, we are also mindful of various challenges facing the Chinese economy over the long run. We believe that China's economy has and will likely continue to experience high growth and relatively low inflation with a cushion against external real or financial shocks, as long as the high savings ratio persists (see again China Economics: The Virtues of ‘Over-Savings': A Post-Crisis Reflection on Chinese Economy). We do not subscribe to the notion that there are serious structural imbalances in China's economy.
However, the ‘over-savings' is not a permanent phenomenon but a function of China's demographics. Population aging in China will likely kick off around 2020, according to projections made by the United Nations. The key challenge facing the Chinese economy is how to seize the window of opportunity of ‘over-savings' to create quality wealth for the nation, in our view. The priority for China's economic development is not about rebalancing the economy but rather improving the quality of investment, or wealth creation, in our view.
To this end, China must get the structure of pricing and other incentives right by:
a) Deregulating the prices of energy and natural resources;
b) Deregulating interest rates;
c) Allowing unfettered adjustment of the real effective exchange rate (either through more flexible nominal exchange rate or domestic inflation, or a combination of both);
d) Deregulating the land market;
e) Deregulating sectors that are still subject to state monopoly (e.g., services); and
f) Encouraging private capital outflows.
Asia Pacific
Domestic Demand - Cyclical Story Intact
By Chetan Ahya | Singapore & Sumeet Kariwala | India
Asia maintains its lead in global recovery cycle: Unlike the previous two cycles, Asia has had a distinct lead in the current global recovery. AxJ industrial production grew 9.5%Y as of September 2009, compared with declines of 12.4% in the EU and 6.1% in the US. Indeed, production levels in AxJ are already well above the peak levels seen in February 2008, whereas EU and US production levels are 16% and 12% below peak, respectively, as of September 2009. Moreover, unlike in previous cycles, the key factor driving recovery is domestic demand - particularly household consumption spending on discretionary items and residential property, and government spending on infrastructure and handouts.
However, we believe the heavy lifting remains to be done, and efforts toward more sustainable long-term domestic demand reflation are far from desirable levels. While we can argue that regional policymakers should respond to the challenge of rebalancing by initiating structural reforms to boost domestic demand on a sustainable basis, doing the right thing is not easy. As the external demand shock crushed growth, policymakers are undoubtedly taking small steps in the right direction. Yet, in our view, the approach toward domestic demand reflation remains piecemeal and, in reality, comprises more short-term stop-gap measures to fill the vacuum created by the collapse in exports rather than being structural.
Loose monetary and fiscal policy have been at the heart of this cyclical boost to domestic demand: AxJ central banks have cut policy rates to unusually low levels. As a result, short-term interest rates have been brought down to just 2.5% from 5.5% in July 2008. We expect the fiscal deficit in the region to expand to 4.0% and 3.5% of GDP in 2009 and 2010, respectively, from a surplus of 0.1% of GDP in 2007. This sharp cut in policy rates and major expansion in the fiscal deficit have played a key role in the revival of the growth trend. Unlike in the previous cycle, the banking system was in a much stronger position this time to ensure quick transmission in the form of improved credit conditions. Government spending also produced more bang for the buck. In previous cycles, the government deficit was also used to bail out the financial sector.
While external demand is improving, recovery to peak levels is some time away: Even after the sharp improvement in the past two months, October exports (adjusted for seasonal factors) are still 19% lower than peak in value terms. In volume terms, the export trend is better, but still 5% lower YoY for AxJ (excluding India and Indonesia) as of September 2009. This gap between value and volume reflects lower commodity prices and inflation. Exports from most countries in the region are 9-15% lower than the peak in volume terms (the exception is Korea, which has outperformed the region, recovering to peak levels). Considering that the region's exporters would have been geared up for about 10-15% growth pre-crisis, capacity utilization in export businesses is still likely to be low. We believe that policymakers will look for revival in external demand and/or sustainability of domestic demand before initiating steps toward meaningful tightening.
Time to reverse extremely accommodative policy? We believe that concerns about inflation remain low. AxJ headline inflation increased to 2.5% in October 2009 from 1.5% in July 2009, mainly driven by food and energy prices. Indeed, the core inflation index in AxJ (excluding India) remains low at 1.3%Y as of October 2009. However, many central banks in the region, including in Korea, India and China, have reflected their concerns of the risk of excess liquidity fueling asset prices. Moreover, the sharp recovery in industrial production may indicate that the time has come to start withdrawing the extraordinary policy support. However, we believe that policymakers will make a distinction between this policy-driven recovery and an autonomous recovery. In other words, they are likely to move gradually in withdrawing policy support until there are strong signs of an autonomous private sector recovery.
Rate hike cycle to begin from 1Q10: We expect India and Korea to go first. Central banks there are likely to increase policy rates by 25bp each in January 2010. Indeed, we can argue that technically India has already moved ahead of Korea, as the RBI initiated the first step toward ‘exit' by discontinuing in the October monetary policy review several unconventional liquidity support measures that were taken immediately after the unfolding of the credit crisis last year. Both the Indian and Korean central banks have been relatively hawkish in the past, and both countries have witnessed a surprise in growth data recently. India has surprised on domestic demand, with almost a vertical rise in IP in the last four months, while Korea's exports in volume terms have grown 8%Y. The rest of the region, meanwhile, saw a decline of 5%Y as of September 2009.
How do we read these potential rate hikes? We see them as a trend towards normalization. The short-term real interest rate on core inflation is very low at an average of 1.2% even as industrial production has accelerated to 9.5%Y as of September 2009. We expect the weighted average policy rate in the region to rise to 5.8% by end-December 2011, compared with 4.6% as of end-December 2009, as core inflation is still very low, with capacity utilization not at levels that are likely to exert pressure. Moreover, as the recovery has been largely driven by a strong policy response, central banks will be conscious of this fact in their pace and timing of tightening.
Risks to our base case: The two key factors to watch in the context of growth and interest rate outlook are the trends in exports and commodity prices. A rise in exports would give comfort that autonomous demand is recovering and encourage policymakers to quicken the pace of tightening. In this context, we tend to watch closely the US ISM New Orders Index (a leading indicator). Similarly, we would also watch commodity prices. AxJ remains a big importer of commodities. Oil prices also tend to influence food prices, and food is a big part of the consumption basket, weighing on inflation expectations.
India
Growth Recovery Gathering Pace
By Chetan Ahya | Singapore & Tanvee Gupta | India
The aggressive global policy response to the 2008-09 economic recession has triggered a meaningful recovery almost synchronously around the world. India is no exception. Various economic indicators have been surprising on the upside, confirming that the economy is on a solid recovery path. Indeed, industrial production (IP) growth accelerated to 10.3%Y during the three months ended October 2009 compared with the trough of 0.3%Y in the three months ended February 2009. The key stimulus for this rebound is the lagged impact of an expansionary fiscal policy and loose monetary policy. However, over the next 12 months, we expect export growth to recover with the private sector assuming the lead, enhancing the growth quality mix. We expect a pick-up in GDP growth to 8% in 2010 from 6% in 2009, to be underpinned by faster private consumption and infrastructure spending growth. A favorable base effect for agriculture will also help. Business investment is likely to remain slow in 1H10 with a modest recovery in 2H10. In 2011, we expect strong GDP growth of 7.6% to be driven primarily by domestic demand but also by a revival in business investment.
V-Shaped Recovery in Industrial Production
Industrial production growth has turned around, accelerating 10.3%Y in October 2009 after touching the bottom of -0.2%Y in December 2008. The seasonally adjusted industrial production index in September increased by 7.4% over May 2009. Unless there is a meaningful decline month-on-month - we think this is unlikely - IP growth should remain strong for the rest of the financial year. Various other economic indicators are also rebounding sharply from lows touched in the quarter-ended December 2008. Growth in passenger car sales picked up during the three months ended November 2009 to average 32.4%Y compared with the bottom of 1.2%Y during the three months ended January 2009. Two-wheeler sales growth also recovered, to an average 38.4%Y during the three months ended November 2009, after easing to a low of 9.9%Y in the quarter ended December 2008. Growth in cement dispatches revived to 10.2%Y in the three months ended October 2009 from the bottom of 5.8%Y in the three months ended October 2008.
2009 - Better Policy Traction and Revival in Risk Appetite
We believe that much of the rebound in IP growth is due to stronger domestic demand while exports remain weak. Faster growth is being driven mainly by the lagged effect of an expansionary fiscal policy and relaxed monetary policy. The traction from the government's policy measures has been better than expected. Moreover, a swift return of the global appetite for risk has allowed India's corporate sector to access risk capital from international capital markets more easily than expected. This has helped corporates repair their balance sheets faster and reduced the risk of a vicious circle of large non-performing loans in the banking system that could have led to increased risk-aversion and slower growth. We estimate that capital inflows into India increased to about US$10 billion (annualized rate of US$40 billion) during the quarter ended September 2009 (QE-Sept 09) compared with an inflow of US$6.7 billion in the QE-Jun 09 and outflow of US$5.3 billion in the QE-Mar 09.
2010 - Shift in Driver from Policy to Private Initiatives
We expect the recovery in GDP growth to be sustained, accelerating to 8% in 2010 from 6% in 2009, even as policymakers gradually start withdrawing monetary and fiscal policy support. Global growth is vital for the recovery. India's growth trend remains highly influenced by capital inflows, and improving global growth should mean more such capital for India, as well as bolstering external demand. We believe that the moderation in government consumption spending will be offset by a significant recovery in external demand and modest pick-up in the investment cycle.
2011 - Growth of 7%-Plus Looks Sustainable
While we estimate that India's headline GDP growth will slip slightly to 7.6% in 2011 because of the normalization of agriculture growth, we expect non-agriculture GDP growth to remain strong at 8.5% compared with 8.8% in 2010. Domestic demand is likely to remain the primary growth driver, but capex, together with private consumption and infrastructure spending, should also underpin growth. We estimate that real gross fixed investment growth will rebound to 8.6%Y in 2011 from 6.4%Y for 2009. While we expect a sharp reversal in monetary policy support in 2010, the fiscal consolidation trend should be maintained through to 2011.
Normalization of Interest Rates Underway
The Reserve Bank of India initiated the first step toward the ‘exit' in its quarterly monetary policy review on October 27, 2009, by discontinuing several unconventional liquidity support measures that were taken in response to the unfolding of the credit crisis last year. In addition, it has tightened prudential norms for loans to the commercial real estate sector and stipulated that banks should maintain a loan loss coverage ratio of 70% by September 2010. This is a clear indication from the RBI that monetary policy is beginning to be reversed. We maintain our view that the RBI will lift policy rates by 25bp in January 2010. By that time, the RBI should have adequate confirmation of the pace of recovery. Indeed, we expect a cumulative increase of 150bp in the repo rate in 2010. However, this potential policy rate hike is unlikely to derail the recovery as it represents a move toward normalization rather than a restrictive policy.
Return to 9% GDP Growth Will Remain a Challenge
We think it will be difficult for India to achieve GDP growth of close to 9%, the rate witnessed prior to the global credit crisis (2004-2007). We see three constraints on growth: First, we believe that the global growth environment will be weaker than during 2004-07. Our economics team expects global growth of 4.0% in 2010 and 3.9% in 2011, compared with average growth of 4.8% in 2004-07. Second, the starting point of elevated levels for the government's revenue deficit and public debt implies that some payback will be inevitable in the form of reduced government consumption spending. Third, while we expect infrastructure spending to increase, we believe that it will be lower than the required 9% of GDP.
Upside and Downside Risks to Our Estimates
We believe that India's growth outlook in 2010 and 2011 will be influenced by two key factors. The more important will be the global growth trend, which will be reflected in the global risk appetite and capital inflows, as well as external demand. The other factor is the pace of structural reforms initiated by the government. The influence of these two factors will form the upside and downside risks to our GDP growth estimates for 2010 and 2011 of 8% and 7.6%, respectively. Based on this framework, we see growth for India in our bull case scenario of 9.5% in 2010 and 9% in 2011; in our bear case, we see 6.5% in 2010 and 6% in 2011.
ASEAN
Prefer Domestic Demand Plays in a Slow and Steady World
By Chetan Ahya, Deyi Tan & Shweta Singh | Singapore
We Prefer Domestic Demand Secular Stories to External Demand Cyclical Stories
With global growth likely to stay modest as rebalancing adjustment gets underway, we favor domestic demand secular stories over external demand cyclical stories. Within ASEAN, Indonesia is the least export-oriented economy, with its export share standing at 27% of GDP, followed by Thailand (64%), Malaysia (90%) and Singapore (185%). The low export share in Indonesia should serve as a buffer against lower global growth trends in 2010-11 compared with 2004-07. In addition, on the domestic front, a confluence of growth-conducive factors such as demographic dividend/natural resources, a structural decline in the cost of capital and a strengthened political mandate should also help to push Indonesia towards its potential growth of 6-7% from 2011.
At the other extreme, Singapore remains the most exposed to the global cycle with its high export orientation. This exposure is further aggravated by policymakers seeming to have added more beta into the macro portfolio with the inclusion of highly cyclical industries such as financials and tourism. Moreover, the growth strategy of catering to global demand means that domestic demand has become less domestic in nature and is inevitably a function of the former.
We Prefer Net Commodity Exporters to Net Commodity Importers
In our view, near-term inflation could remain subdued. However, unlike in the last cycle, inflation pressures could come back sooner over the medium term as the one-off structural factors underpinning the ‘Goldilocks' nature of 2004-07, such as the entrance of huge excess capacity into the trading system (e.g., China), are no longer present. On near-term inflation, while core inflation is likely to remain relatively low, given the buffer from excess slack, headline inflation could see a step-up from a reversal in base effects from commodity prices amid the tight supply-side dynamics.
Based on the latest oil futures, oil prices could be expected to average US$84/bbl and US$87/bbl in 2010 and 2011, up from US$64/bbl in 2009. In this regard, we would prefer net commodity exporters over net commodity importers as a ‘hedge'. Malaysia and Indonesia are the top two net commodity exporters within Asia. Singapore and to a lesser extent Thailand are net commodity importers. Coincidently, net commodity exporters in ASEAN also tend to have a retail fuel subsidy system. Ceteris paribus, not only will there be a net transfer of commodity dollars from elsewhere to these economies, but the internal transfer of income from consumers to producers will also be mitigated, allowing the positive spillover from the commodity prices to be more widespread.
We Prefer Economies Where Policymakers Implement Aggressive Policies Could Offer More Domestic Demand Alpha
In ASEAN, we think 2010-11 will entail a phasing out of policy stimulus at a gradual pace. However, in the case of Thailand, the flow of events and the implementation timing of the second stimulus package mean that fiscal policy (including extra budgetary spending) is likely to get more expansionary in 2010 (versus 2009) while others are winding down their fiscal policies. Thailand is running an aggressive policy response because macro conditions have been dampened by the political climate. However, we think that the size of the stimulus package, the improvement in government execution, and the potential crowding-in from the private sector as improved execution is perceived as a pick-up in political conditions will mean that the policy response could offer the most alpha to domestic demand for Thailand. Separately, we prefer Malaysia and Singapore over Indonesia in this aspect. Malaysia is typically more fiscally accommodative, while Singapore has the strongest government balance sheet in ASEAN.
What's the Pecking Order?
Taking the above into consideration, we like Indonesia the most. Our rankings for Thailand, Malaysia and Singapore fall within a tight range. We see Thailand and Malaysia as offering similar growth prospects. However, we rank Thailand ahead of Malaysia because of the positive expectation gap (relative to the market's perception) that we expect on fiscal implementation. Lastly, we think that Singapore would find it hardest to extract growth in the global environment that we envisage.
What Are the Key Risks?
The risks around our global growth forecasts are evenly balanced. Similarly, the risks are also somewhat evenly balanced around our base case of 0%Y for 2009, +4.8%Y for 2010 and +5.4%Y for 2011 for ASEAN4 GDP. We remain comfortable with Indonesia being our top preference in our bull, base and bear case scenarios. On the other hand, while we are comfortable with our baseline, Singapore is where we run the highest possibility of being wrong, in terms of both growth revisions and ranking preference, due to its high-beta nature.
We think that the global rebalancing process needs time to bear fruit, which will have implications on the sustainability of a V-shaped trajectory beyond inventory adjustments. However, if we are wrong and upside risks do pan out, Singapore will benefit most, given its high-beta nature. Our preference rankings in this scenario would be Indonesia, Singapore, Malaysia then Thailand. Having said that, our global colleagues also note that even this blow-out scenario could be a short-lived growth spurt. Surging global growth could push up inflation and cause aggressive policy tightening in 2011. This could well push the global economy back into a more conventional, policy-induced recession in about two years' time. On the other hand, with the recent global recession having purged much of the imbalances, our global colleagues highlight that the main downside risk is now a premature policy reversal with macro fundamentals failing to grab the growth baton when that happens. In this scenario, our preference rankings would stay the same as in our base case.
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