China’s 1H08 economic report offered yet more evidence of an ‘imported soft landing’ that we had envisaged for the economy. Real GDP growth slowed to 10.1%Y, from 10.6% in 1Q and 11.9% in 2007, on the back of slower export growth (+10.9%Y in 2Q08 versus +12% in 1Q, in renminbi terms). In June in particular, year-on-year export growth in renminbi terms dipped into single-digit territory, its weakest level in more than six years (see Single-Digit Export Growth in RMB Terms, July 11, 2008). Robust Domestic Demand Cushioning Against External Downturn China’s trade surplus has shrunk noticeably in 1H08 amid weakening exports yet resilient domestic demand and surging costs of imported energy and commodities. The trade surplus shrank by 12%Y to US$58.2 billion in 2Q08, extending the trend seen in 1Q. The net exports position therefore contributed negatively to overall GDP growth for the second straight quarter, by around 0.9 percentage points (pp) according to our estimates (-0.7pp in 1Q). Domestic demand strength helped offset the negative contribution from weaker external trade. We estimate that domestic demand contributed 11pp to overall GDP growth in 2Q (+11.3pp in 1Q). Consumer demand, as reflected in retail sales, grew 22.2%Y in 2Q (+23% in June). After adjusting for inflation in the period, we estimate that retail sales gained 13.6% in real terms, further accelerating from 12.3% in 1Q (+12.5% in 2007). Fixed asset investment (FAI) also actually accelerated noticeably in 2Q08, totaling Rmb4.66 trillion, up 27.1%Y (+24.6% in 1Q). The acceleration in urban FAI was especially sharp in June, up 29.5%Y (+25.4% in May and April), possibly related to post-earthquake reconstruction. Consumer Inflation Eases Further Though Upstream Inflation Worsens As we forecasted, using high-frequency food price data (see our weekly Food Price Inflation Monitor publication), CPI inflation eased to 7.1%Y in June, down from 7.7% in May. On a month-on-month basis, consumer prices retreated by 0.2%, bringing the overall price level down 1.2% from the peak in February (amid snowstorms). The food price level has corrected by 3.9% from the February peak, we estimate, while year-on-year food inflation has eased to 17.5% (our estimate) in June, from 19.9% in May (peak of 23.3% in February). Non-food inflation, on the other hand, has picked up to 2%Y (our estimate) in June, on the back of the hike in fuel prices, up from 1.7% in May. Upstream inflation, on the other hand, had continued to accelerate amid further rises in energy and raw materials costs. PPI (+8.8%Y in June, +8.3% in 2Q versus +6.9% in 1Q) and RMPPI (+13.5% in June, +11.1% in 2Q versus +9.9% in 1Q) both exceeded our forecasts. The continued uptrend in upstream inflation versus easing consumer inflation again reminds us of the tough environment that producers face this year. As we argued before, even if food prices do not fall further (down 3.9% cumulatively in March-June) from the current level, year-on-year inflation will continue to ease in the remainder of the year on the high base for comparison. We project the year-on-year food inflation to ease to single-digits in 4Q08. Meanwhile, taming food inflation will allow more price hikes by the government in energy and utilities, the next round of which we believe could take place after the Olympic Games. Non-food inflation, therefore, will become a more dominant driver of inflation ahead. Reflecting the development in 1H08, we are fine-tuning our full-year 2008 inflation forecast to 7%, from 6.5% originally. Maintaining Our 2008 Growth Forecast and Policy Call The latest data represent further evidence of the dichotomy of external weakness and domestic strength, consistent with our call for an imported soft landing this year. The latest figure puts us on track to reach our full-year GDP growth forecast of 10%. We forecast that slower exports (+17.5% in USD) against the surging import bill (+23.1%) will shrink China’s trade surplus to US$255 billion this year – the first decline since 2003. Net exports’ contribution to GDP growth will turn negative, to -0.4pp, from over +2pp in the last three years. On the policy front, guided by our long-standing call featuring ‘three no’s’ – no campaign-style administrative tightening, no large one-off revaluation of the renminbi exchange rate and no interest rate hike – we think the authorities could take a set of more concrete policy actions in the remainder of the year. In particular, we believe that the policy orientation has turned toward preventing economic slowdown (see Dissecting Policy Uncertainty, July 7, 2008). Although fighting inflation is still of high priority, we believe that the hawkish tone from the policymakers is mainly to help manage inflation expectations, with no additional tightening measures being contemplated. Amid the marked slowdown in exports in the face of weaker demand from developed markets in the aftermath of the subprime crisis, we stand by our call that government policies will remain supportive of domestic demand growth. Specifically, we expect: a) More exporter-friendly measures to be adopted, including slower renminbi appreciation and higher VAT rebate to exporters; b) While RRR hikes – as a liquidity management tool – will continue to be employed, administrative controls over bank credit are to be eased such that the ambitious bank credit growth target for 2008 determined at the end of last year will likely be exceeded by 1-2pp by year-end; c) Energy price liberalization to continue, with the next refined product price hike (e.g., 10-20%) likely in late 3Q or 4Q; d) Fiscal subsidy to farmers and low-income urban households to be increased, which will, in part, be financed by fiscal savings from energy subsidy reduction; and e) In the event of a sharper-than-expected slowdown, the policy stance (especially fiscal policy) could be eased further toward year-end. Looking to 2009 – Hurt by Weaker Global Economy Looking to 2009, we now see growth facing more pronounced downward pressure from weakening exports. We are revising our 2009 GDP forecast to 9%, from 9.5% originally. First, China’s external environment will become even less supportive in 2009 than 2008. Our global economics team now forecasts that the GDP growth rates in both the US and Eurozone will likely decline substantially in 2009 from their 2008 levels (i.e., from 1.5% to 0.7% in the US and from 1.5% to 1% in the Eurozone). We expect that weaker external demand – together with the trade-impeding impact of high transportation costs due to high fuel prices – will result in further deceleration in China’s export growth, which we forecast to dip to 12% in 2009, from 17.5% in 2008. Second, the cumulative effect of continued normalization of domestic energy prices will lead to cost pressures and profit margin squeeze – especially in the sectors of high energy intensity − dampening investment demand in these sectors. With energy price normalization to feature more prominently going forward, we expect non-food price inflation to continue to creep up in 2009. In this context, we raise our headline CPI forecast for 2009 to 4.0%, from 3.5% previously. The risk to this revised outlook is broadly balanced, in our view. Specifically, with moderation in headline CPI inflation in 2009, we expect the policymakers to stand ready to launch growth-boosting policy initiatives in the event of a weaker-than-expected economic performance, limiting the downside risks. Despite cyclical weakness in both exports and investment, we expect consumption expansion to continue to be dominated by its secular strength.
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Rising Macro Risks; Lowering Growth Estimates
July 18, 2008
By Chetan Ahya | Singapore & Tanvee Gupta | India
Summary After three years of above-trend growth, India is now facing challenges from an adverse global macro-environment that has increased the risk of pushing the country's growth below sustainable levels. Higher oil and other commodity prices have heightened inflation concerns. The depreciation of the rupee is likely to add to the inflation pressure. Political tolerance for inflation is low, considering that 10 state elections are scheduled over the next 12-15 months, followed by a general election due to be held by May 2009. Moreover, we believe that the economy could also suffer from potential continued risk aversion in the global financial markets, which has already affected the corporate sector's ability to raise funds from the international markets. In light of the deteriorating macro-environment, we are lowering our 2009 growth estimate to 6.9% from 7.5%. On a financial-year basis, we are expecting F2010 (12 months ending March 2010) GDP growth to be 7%, versus our earlier forecast of 7.6%. A Repeat of the Mid-1990s Cycle? The current cycle reminds us of the developments in the mid-1990s growth cycle (see Overheating Signs – Reminiscent of 1993-96 Cycle, February 27, 2007). To be sure, sustainable growth in the current cycle is much higher than in the previous cycle, and the Indian corporate balance sheet is in very different shape today than it was in 1993-98. India’s external balance sheet is much stronger, with lower external debt to GDP and a high level of FX reserves. The corporate sector is far more efficient and competitive. Hence, we think that the trough of the growth is now likely to be much higher than the lows it touched during 1997-98. However, a turn of macro events does bear some strong resemblance to the mid-1990s cycle. As in that cycle, a favorable emerging market environment accentuated the acceleration in the growth trend to the overheating zone in the current cycle. Total capital inflows into India increased to US$98 billion in 2007 from US$12 billion in 2002, mimicking the overall EM capital inflows trend. We believe that these large capital inflows played a key role in boosting India's growth cycle to above-sustainable levels. Capital inflows resulted in a sharp fall in real interest rates, boosting domestic demand. In the mid-1990s, weak capacity growth (particularly in the infrastructure sector) relative to domestic demand growth pushed inflation to double-digit levels during 1994-95. The spike in inflation concerned the policy-makers, particularly as general elections were scheduled for 1996. The high level of interest rates slowed consumption growth. We believe that we are in a similar state now. Domestic demand growth has already slowed. Similar to the mid-1990s, an adverse global macro-environment could cause a further deceleration in GDP growth below sustainable levels. Worsening Growth Environment While growth has already reverted to more sustainable levels, the global macro-environment is now likely to force a further slowdown. Just as during 2005-07 strong positive global factors supported India's growth above its then-sustainable growth trend, negative global factors are now threatening to pull its growth below trend. The most important adverse factor is the global commodity price trend. While India is self-sufficient in steel and aluminum, it is heavily dependent on imported copper (concentrate), coking coal, edible oils and, most important, crude oil. Even for commodities where the country is self-sufficient, market-oriented pricing means that some indirect pressure on domestic pricing of global commodity products is inevitable. This is evident in the recent spike in prices for domestic steel, iron ore and certain food products. High oil prices continue to be a big challenge for the country. India imports about 70% of its crude oil and refined products requirements. Since the government has increased domestic fuel prices by only 39% for petrol and 45.6% for diesel (average for the country) over the last four years while international crude oil prices (WTI) have shot up about 238.5% to US$138/bbl currently, the subsidy burden continues to spike. In F2009, if we assume that the crude oil price trend in the rest of the financial year follows the oil futures path, the average for the year would be US$135/bbl. At a US$135/bbl average in F2009, we believe that the oil subsidy (including the burden on oil companies) will increase to US$39.7 billion (3.2% of GDP). Domestic oil products are marked to an implied average of US$80/bbl. If the government were to hike domestic product prices to the current level of crude oil prices, inflation would rise by about 3.9ppt. Increasing the oil subsidy will push the fiscal deficit to double-digit levels. The government has continued to pursue a loose fiscal policy over the last few years. Apart from a higher oil subsidy, the government will be bearing the off-budget burden of fertilizer subsidy, food subsidy and farm loan waiver costs. The government’s announcement of a wage hike for its employees will also add to the deficit burden. We expect the combined central plus state government fiscal deficit (including all off-budget spending) to rise from an estimated 7.7% in F2008 to 11.4% of GDP in F2009 (assuming that oil prices average US$135/bbl during the period). Rising current account deficit and slowing capital inflows add to macro challenges. A roughly US$10/bbl increase in crude oil prices results in higher imports, a trade deficit, and a current account deficit of US$7 billion (0.6% of GDP). Assuming average crude oil prices of US$135/bbl, we expect the current account deficit to reach 3.5% of GDP in F2009. A widening deficit at a time when capital inflows are slowing means increased pressure on the exchange rate. Increased risk aversion in the global financial markets is resulting in slowing capital inflows in emerging Asia in general and in India in particular. India received total capital inflows of US$108 billion during the 12 months ended March 2008 (an average of US$27 billion per quarter). Capital inflows slowed to US$13-15 billion during the quarter ended June 2008, as per our estimates (based on the trend in FX reserves data). We believe that total capital inflows could slow further from here. This would increase the pressure on the government to consider an option to encourage public sector banks to raise a large US$15-20 billion worth of dollar deposits from non-resident Indians (a move that was implemented in the form of Resurgent India Bonds in August 1998 and the India Millennium Deposit in November 2000 to reduce the stress on balance of payments). The rupee has already depreciated by 9.9% over the last six months. We expect the rupee to depreciate by another 6-7% by December 2008, adding further to the pressure on inflation. Inflation to remain in double-digits until May 2009. We believe that if crude prices remain at current levels, the government will likely be forced to hike domestic oil product prices by another 10% by September 2008. Assuming a 10% increase in domestic oil product prices and a stable trend for other global commodity products, we expect inflation (WPI) to rise to 15.7% by December 2008 before it moderates to 11.7% by March 2009. More policy rate hikes coming. Monetary policy will need to remain tight to address the concerns of a second-round impact of higher commodity prices as well as to prevent major depreciation in the exchange rate. We expect the central bank to hike the policy rate by 50bp to 9% over the next three months. We expect 10-year bond yields to rise to 10.25-10.5% by December 2008, due to increased uncertainties surrounding the inflation outlook and slowing capital inflows. We see a risk of an additional hike of 25-50bp in the policy rate if crude oil prices jump above US$150/bbl in the near term. Similarly, if crude prices fall below US$125/bbl in the near term, the RBI could delay its rate decision. We are now looking for a downward growth trajectory through to 2009. Building in the deteriorating macro-environment, we expect C2009 GDP growth to be 6.9%, compared with our earlier estimate of 7.5%. On a financial-year basis, we are expecting F2010 GDP growth to be 7%, down from our earlier estimate of 7.6%. The downside risks and upside revision to our estimates will depend on the trend in global commodity prices and the duration of the pain in global financial markets. Corporate profit to GDP to witness downside pressure like in the 1993-98 cycle. During the 1993-98 cycle, the Asian crisis and resultant risk aversion in the global financial market prolonged the down-cycle. The Indian corporate sector suffered major negative operating leverage after having increased business investments. Private corporate capex had risen from the trough of 6.1% in F1994 to 10.4% in F1996. Indeed, in the current cycle, private corporate capex has increased at a higher pace to an estimated 15% of GDP in F2008 from the low of 6.6% in F2004. We believe that the current adverse global macro-environment is increasing the risk of a prolonged domestic demand slowdown, resulting in negative operating leverage for the corporate sector again.
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Fiscal Measures Address Inflation
July 18, 2008
By Denise Yam | Hong Kong
Government unveils fiscal measures to address inflation: In response to mounting social pressure, the SAR Government Chief Executive Donald Tsang proposed several fiscal measures to alleviate the impact, particularly on low-income to middle-class households. Measures total HK$11 billion, equivalent to 0.7% of GDP, spread over two years: The announced proposals, yet to be passed by the Legislative Council on July 18, involve the spending of HK$11 billion from the government coffers. These include one-off social security benefits (HK$1,000 student financial assistance, two extra months’ of Old Age Allowance, one extra month’s of Comprehensive Social Security Assistance and Disability Allowance), waiver of levy on foreign domestic helpers for two years (HK$9,600 per household), freezing of government fees and charges, extension of electricity charge subsidies by six months (up to HK$3,600 per household) and HK$100 million earmarked for short-term food assistance services. In addition, the MTR will offer fare concessions to students to alleviate the burden of transport costs on families with children who attend schools located far away from home. The fiscal ‘stimulus’ totals HK$11 billion, equivalent to 0.7% of GDP. However, this will be spread over two years, and therefore will provide a limited boost to economic growth or additional inflationary pressure. CPI inflation forecast remains at 4.5% for 2008: While we saw upside risk to our current inflation forecast of 4.5% for 2008 before the latest measures were introduced, we now maintain this forecast, which we see as sensible at this juncture. Mid-single-digit inflation is still moderate by international and historical standards: At mid-single-digits, inflation in Hong Kong is still manageably moderate, by international as well as historical standards. Double-digit inflation prevailed in Hong Kong throughout most of the 1980s and early 1990s. Nevertheless, the rapid change in pricing dynamics in the past couple of years, and the notable acceleration in inflation after six years of deflation, certainly brought about redistribution effects across income as well as functional groups in the economy. We welcome fiscal measures at this juncture to ease such redistribution effects, so as to lessen the social impact of inflation. Fiscal measures to dominate the policy space for now; not yet time to tinker with the exchange rate: Although the Hong Kong government ran budget deficits for a few years, it still possesses a considerable pile of reserves, which total HK$487 billion at the end of May, equivalent to 30% of GDP. This comfortable buffer offers the government considerable fiscal flexibility in managing the economy, which is much appreciated in the case of Hong Kong, where there is no monetary policy flexibility under the fixed exchange rate system. At the current juncture, we believe that fiscal measures can continue to play a dominant role in economic policy. The latest package demonstrates exactly that, consistent with our view that it is not yet necessary to tinker with the exchange rate, especially when the renminbi and other Asian currencies have shown some slowdown in their pace of appreciation of late.
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